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All trading basics

Top-down or bottom-up?

Are you the top-down or bottom-up type? This may surprise you, but what we see here are two major schools of thought in the investment world. The top-down approach, as its name indicates, is an analytical process that goes from top to bottom and generally consists of three steps. The investor starts by examining the economic situation at the national or international level to see if the outlook appears favourable for equity markets. This exercise can usually help identify the industrial sectors with the greatest promise over the following 12 to 36 months. Investors can then identify the stocks that seem most worthwhile for their portfolios.

Followers of the top-down approach believe the general economic situation and the strength of a particular industrial sector have a considerable impact on share yields and that investors clearly must conduct a search based on these two levels of analysis when the time comes to select securities for their portfolios. The economic environment exerts a determining influence on company profits and on investors' attitudes and expectations, and this necessarily affects the market prices of shares. For followers of the top-down approach, ignoring this reality means running enormous and useless risks that are likely to cause serious harm to a portfolio.

The bottom-up approach, going from bottom to top, consists not so much of doing things in reverse but rather of selecting stockswithout attaching too much importance to analysis of a particularindustrial sector or of the overall economic situation.

Adepts of the bottom-up approach, such as Warren Buffett or Peter Lynch, say it is always possible to discover an extraordinary company with shares trading on the market at less than their realvalue, especially when the company has substantially above average growth potential. This applies regardless of the health of its particular area of activity or of the economy in general. To sum up, the bottom-up approach suggests buying shares in companiesthat are relatively self-contained, with considerable independence from their economic environment and an ability to ensure development on their own.

The top-down and bottom-up approaches apply as much totechnical analysis as to fundamental analysis. The type of technical analysis referred to as top-down encourages investors to make a diagnosis using charts of various indices showing the general direction taken by the markets. If the trend is favourable and certain industrial sectors stand out as obviously more "positive" than others, investors should then pay particular attention to stocks showing the clearest upward signs, with the lowest downward risk in the coming months. A bottom-up type of technical analyst will follow a much more direct route, focusing immediately on the stock charts of individual companies.

A very large majority of financial analysts working for brokerage firms advocate a top-down style of fundamental approach. If you buy shares in a company based on recommendations issued by analysts, consider yourself to be an investor influenced by the top-down method. Each of the two investment philosophies has its advantages and its disadvantages. Bottom-up fundamental analysis of a company can be done with a fairly modest toolkit, easily accessible to the amateur investor, whereas top-down fundamental analysis requires a far more ample toolkit that usually only professional investors can afford.