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Avoid Top Down Approach in Your Stock Investment Plan

By Charles Livingstone

If you've heard fund bosses talk about the way that they invest, you know many employ a top down approach. First, they decide what proportion of their portfolio to allot to stocks and how much to allot to bonds. At that point, they might also decide on the relative mixture of foreign and domestic stocks. Next, they decide on the industries to make an investment in. It isn't till all of these calls have been made that they get down to investigating any special instruments. If you suspect rationally about this approach for but a moment, you'll recognise how actually stupid it is.

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

Now, if these low P / E stocks had extraordinarily unsteady takings or carried a great amount of debt, the spread between the long bond yield and the takings yield of these stocks could be justified. Nevertheless many low P / E stocks basically have more steady takings than their high multiple family. Some do employ a good deal of debt. Still, inside latest memory, one could find a stock with a revenues yield of eight 12%, a dividend yield of 3- five percent, 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 purchasing a truck without also considering a vehicle or wagon.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical.

Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it's false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he's comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher's handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher's handedness is merely one factor (among many) to be considered, not a binding choice to be made.

The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn't determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is attractive. Likewise, you needn't determine whether "the market" is undervalued or overvalued; you need only determine that a particular stock is undervalued. If you're convinced it is, buy it - the market be damned!

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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