What's the difference between "top-down" and "bottom-up" investing?

Before we look at the differences between top-down and bottom-up investing, we should make it clear that both of these approaches have the same goal - to ferret out great stocks. Now, let's look at the different strategies used by top-down vs. bottom-up investors to select companies in which to invest.

Top-down investing involves analyzing the "big picture". Investors using this approach look at the economy and try to forecast which industry will generate the best returns. These investors then look for individual companies within the chosen industry and add the stock to their portfolios. For example, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the home-building industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.

Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. What constitutes "good prospects", however, is a matter of opinion. Some investors look for earnings growth while others find companies with low P/E ratios attractive. A bottom-up investor will compare companies based on these fundamentals; as long as the companies are strong, the business cycle or broader industry conditions are of no concern.