All About Against The Top Down Approach To Picking Stocks

If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for but a moment, you will recognize how truly foolish it is.

A stock’s takings yield is the inverse of its P / E proportion. Therefore a stock with a P / E ratio of twenty-five has a revenues yield of 4%, while a stock with a P / E proportion of 8 has a takings yield of 12.5%. In this fashion, a low P / E stock is equivalent to a high yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

All investments are finally money to cash operations. As such, they need to be judged by a single measure : the discounted cost of their future money flows. Because of this, a top down approach to investing is nonsensical. Beginning your search by first deciding on the kind of security or the industry is a general boss deciding on a left handed or right handed pitcher before assessing every individual player. In every case, the choice isn’t simply hasty ; it’s fake. Regardless of whether pitching left handed is inherently better, the general executive isn’t comparing apples and oranges ; he is comparing pitchers. Whatever inherent advantage or downside exists in a pitcher’s handedness can be reduced to an ultimate price ( e.g, run worth ). Because of this, a pitcher’s handedness is simply one factor ( among many ) to be considered, not a binding choice to be made. The same’s true of the kind of security. It is neither more required nor more logical for a stockholder to like all bonds over all stocks ( or all outlets over all banks ) than it is for a general chief to like all lefties over all righties. You need not decide whether stocks or bonds are tasty ; you need just establish whether a particular stock or bond is alluring. Likewise, you need not resolve whether the market is undervalued or unrealistically priced ; you need simply decide a particular stock is undervalued.

If you are convinced it is, purchase it the market be damned! Clearly, the most judicious approach to investing is to guage every individual security re all others, and only to think about the type of security insofar as it has effects on every individual analysis. A top down approach to investing is a pointless impediment. Some really smart investors have imposed it on themselves and conquer it ; there’s no need for you to do the same.

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