Top down vs Bottom up
You may have heard these two phrases. Here are plain english explanations:
Top down: making your investment decisions based on your overall view of the economy, countries, what’s going on in the world and then deciding how that will impact stock prices. Eg you think Britain will struggle after Brexit so you sell all UK stocks and buy French ones instead.
Bottom up: making your decisions based on individual view of a single company. You focus on how well you think a single company is going to do and invest based on that. Eg you think everyone’s going to drive electric cars, and the best electric car is a Tesla so you buy Tesla stock.
An awful lot of the commentary you see in the news, and research that you read, and people that you talk to will be top down investors. There are even professional investors making millions of pounds a year in careers as strategists and economists and forecasters of top down trends. The problem is, most of them get it wrong most of the time. Some do get it right occasionally, do any get it right consistently?
The reason why is pretty simple when you think about it. If you’re making a call based on a country, or a stock index (as most of these calls are), you have to forecast literally hundreds of thousands of individual variables. An index is affected at any one time by: interest rates in every country in the world, wars, news, politics, individual company results, individual company director moves, purchases/sales, flows of assets etc etc. There are thousands of individual variables determining any individual index level at any point in time.
Do you really think you can reliably and consistently forecast all of those variables? Obviously not.
And even if you could reliably and consistently forecast hundreds of thousands of individual variables to correctly guess a stock index’s movements, you’d then have to also predict how thousands of investors would react to each of those individual variables- because just because something went up or down or some news came out or some political thing happened, doesn’t mean investors will react in the same way to it- markets are full of emotion, herding, swings and sentiment and you’d also have to predict all of that, for millions of market participants and algorithms. Again, it seems pretty obvious that resting your livilhood on your ability to do any of that, is nonsense.
That doesn’t stop people from making a living doing it though- as humans we’re all desperate for someone to tell us the future. Doesn’t matter if they can or not, since the dawn of humanity there have always been forecasters, truth tellers and now economists and strategists who claim to be able to see the future. And get rewarded handsomely for it.
2,000 years ago they used to forecast the harvest based on things like if they saw an eagle flying with a snake in it’s claws, and nowadays some over- paid strategist from Goldman Sachs will claim to know where the S&P 500 is going based on a load of pretty charts and ‘data’. It’s the same thing, and it’s as useless. Ignore it all.
Bottom up investing is the only logical way to approach things for most people- pick a company and do your homework on the business. In that small confined area you’ll be able to make a reasonable judgement as to whether that business is likely to grow or shrink over the next 10 years. If you can pick ones that are growing and you don’t pay too much for them, you’ll have great returns. No need to complicate it any further than that.