With the thousands of stocks, mutual funds, ETFs, bonds and other securities available, how do investors know what to invest in to maintain the right portfolio for them? To start, investors can allocate assets using one of two broad approaches: top-down or bottom-up.
Fisher Investments generally utilizes the top-down approach—a process focusing on the broad, impactful decisions that we believe drive the majority of a portfolio’s return. Asset allocation is the mix of asset classes—stocks, bonds, cash and other securities—that would make up your portfolio. We believe the allocation of investments into these asset classes will dictate about 70% of your portfolio’s long-term return. Therefore, it is important to be sure this asset mix is appropriate for your personal situation and goals.
The 70/20/10 funnel approach to investing roughly illustrates our top-down process and the approximate impact of each step’s selection decision on returns. (Exhibit 1) Imagine a funnel, wide at the top and narrow at the bottom. At the top of the funnel, we analyze overarching economic, political and sentiment drivers. We believe these factors drive the markets over the intermediate term. Based on those drivers, we formulate an expectation of how the stock market should perform in the short term. Our analysis of likely market conditions influences how we allocate assets in a portfolio.
Exhibit 1: Top-Down Investing Process
*Forward-looking return attributions is an approximation intended for illustrative purposes and should not be considered a forecast of future returns or return attribution.
We believe sub-asset allocation within asset classes—such as stocks and bonds—contributes approximately 20% to a portfolio’s return. For example, sub-asset allocation for stocks includes characteristics such as country, sector, size and style. Again, economic, political and sentiment drivers can affect what categories may be more favorable to invest in.
Once we have determined the categories we feel are likely to outperform in the current market environment, we take the last step and select individual positions, which we believe accounts for the final 10% of a portfolio’s long-term return. Our approach is to invest in companies we think will perform like—or even outperform—their respective categories. We believe this strategy allows our clients to benefit from our higher-level themes, maintain a diversified portfolio and achieve longer-term investment objectives.
Conversely, the bottom-up approach to investing describes the process of picking stocks based on company-specific criteria—otherwise known as stock picking. These criteria could be specific factors such as volatility, a certain threshold of valuations or other factors. The emphasis is on specific stock picking instead of overall asset allocation. Many investment managers employ this bottom-up approach, but we believe it could be dangerous if not done carefully. Stock picking could lead you to have a portfolio that isn’t optimal for your goals or personal situation. It can also lead to an incoherent mix of securities or even under-diversification.
While we acknowledge that stock selection can affect returns, we believe bottom-up stock picking focuses too much on attempting to select certain outperformers regardless of overall categories and themes. Instead, the top-down approach focuses on the higher-level themes to help create a diversified portfolio that we believe would be right for you.
Selecting individual companies to invest in requires significant quantitative analysis and scrutiny. Although we believe the majority of long-term portfolio performance comes from properly selecting asset allocation and sub-asset allocation, it is also important to carefully select the individual companies you will invest in.
Some of the characteristics to consider are the following:
Investors have access to more information now than ever. To begin your research into a specific company, we suggest you take time to read all relevant and publicly available information you can find: annual reports, company filings, press releases, media profiles, interviews, trade publications and more. This practice can give you more insight into how the company works and what drives its management and revenues. We suggest you read annual reports front-to-back, even the footnotes. Sometimes the whole picture may not be immediately apparent from just a summary or solely the main report text.
It is also a good idea to listen in on the conference calls of the company you are interested in, and those of its competitors, suppliers and customers. This will give you a broad sense of industry trends and reveal whether your target company is setting these trends, bucking them or being swamped by them.
You should diversify your investments to capture the benefits of style and category outperformance over time. Holding only a small number of stocks or investing everything in a single sector can introduce significant risk into your portfolio. Selecting a few individual stocks for your portfolio brings its share of potential risks, including, but not limited to:
Investing in individual stocks can be a fun hobby, or something you could do with money on the side. However, using the bulk of your resources to pick individual stocks rather than create a portfolio tailored to you can result in unnecessary risk. It could lead you to make short-term or emotional trade decisions or end up with a portfolio that may not be diversified enough. Before you select your investments, we believe you should consider how you are allocating your assets. You should base your decisions on your goals, needs, risk tolerance and time horizon.
Applying a top-down investment approach can help diversify your portfolio and tailor it to you. However, it may be difficult for individual investors to actively manage their investments, spend the time necessary to research market trends and maintain the discipline to achieve their long-term financial goals. We believe a trusted adviser may be able to help.
Fisher Investments continually monitors markets for changing trends and reviews your goals and objectives to make sure your portfolio is on track. Contact us today to learn more about how our top-down investment approach may work for you and how we can help you with your portfolio allocation strategies. Alternatively, download one of our many educational investing guides to gain more insight.