In past blog posts we have discussed some of the different investment styles commonly followed by wealth managers including the growth versus value styles as well as the reasons behind why some wealth managers will tend to favour large cap stocks over smaller capitalization companies, or vice versa.

A wealth manager’s investment philosophy can also be analyzed in terms of the approach that he or she uses when developing forecasts for markets, sectors and individual companies.

The two most widely followed investment philosophies in this respect are top-down and bottom-up investing approaches.

In this blog post, we’ll compare these two investment philosophies, the inputs used by each approach as well as how the two approaches can be used in a complementary manner to help wealth managers develop more complete and accurate forecasts as part of their portfolio management strategy.

Top-Down Analysis

When conducting top-down analysis, wealth managers will begin by analyzing the outlook for several key macroeconomic variables in order to help them come up with forecasted returns for different asset classes.

High level, broad factors like gross domestic product, the level and direction of interest rates, the extent of unemployment present in the economy as well as expectations for future inflation will all be considered by analysts in order to formulate their expected returns for assets like stocks, bonds, real estate, and commodities.

This analysis is used by wealth managers in helping them to identify the asset classes, sectors and markets which they believe will have the best chance to outperform the market over the forecast period, with the top-down approach being of particular value to wealth managers who are pursuing a tactical asset allocation strategy rather than one focusing on making individual security selections.

Bottom-Up Analysis

Unlike the top-down approach which focuses primarily on the analysis of macroeconomic variables, bottom-up analysis instead places emphasis on the outlook for certain key microeconomic, or company-specific, factors.

Bottom-up analysts, sometimes referred to as ‘fundamental’ analysts, will conduct thorough due diligence on such factors as the prospects for a company’s products, the technology it employs, as well as any new services expected to come to market before arriving at an outlook for its future earnings and sales growth.

Fundamental analysts will also consider other internal factors such as a company’s management and personnel, its historical operating performance as well as any planned strategic initiatives when conducting their company research.

The analyst will then incorporate the findings from their research as part of a valuation model to help determine if the company’s shares or over or undervalued relative to the rest of the market.

Some wealth managers may also opt to take the level of analysis one step further by aggregating their forecasts for individual companies in order to arrive at an outlook for a specific industry, sector or geography.

Combining Top-down and Bottom-up Research

As a general rule, the top-down approach begins with a high-level view towards the global economy and from there moves towards a more narrow view of specific asset classes and global industries.

The bottom-up approach meanwhile starts from the specifics and moves towards a more general view of the overall economy.

Most portfolio managers find it’s best to employ both approaches when developing their economic forecasts.

The reason being simply is that more often than not these two different approaches will end up yielding disparate outlooks for the markets they are purporting to represent.

For example, there have been criticisms that the bottom-up investment philosophy has at times been overly optimistic at market peaks while also being overly pessimistic at market troughs, or bottoms.

While the criticism that has been leveled at top-down analysis is that it tends to be centered around the extrapolation of recent history to attempt to predict the future and that this carries the risk of sometimes leaving investors unprepared for unexpected exogenous shocks to the economy.

In this respect, reconciling top-down and bottom-up forecasts can prove a valuable exercise for analysts and wealth managers by helping them to better appreciate the underlying consensus held by overall market as well as by presenting a better picture of the rationale in support of any discrepancies between the two approaches.

Real estate analysts who a decade ago alerted their superiors to the excesses taking place within the U.S. residential housing market were instrumental in helping their firms to re-evaluate what in hindsight were overstated forecasts for economic returns.

By doing so these analysts would have also helped their wealth manager’s clients to avoid outsized losses that led from the eventual collapse of Lehman Brothers.

Conclusion

The more complete an understanding that an investor has about his or her wealth manager’s investment philosophy, the more productive and enjoyable that relationship stands to be.

Investors and their advisors should do their best to work together to foster an environment of transparent and open communication about the philosophies and thought processes that go into the investment management framework.

As a result, investors will be in a better position to know what questions they should be asking of their wealth manager as well as how to respond to their advisor’s explanation of the activity taking place within their investment account.

We believe all Canadians should have a safe place to ask questions.

We’re finance nerds who want to share our love of wealth management with Canadians. Our experience has taught us that many Canadians don’t have a resource to turn to when they want to make a wealth management change or simply want to know more about the Canadian investment landscape. Whether you’re an experienced investor or a beginner we’d love to hear from you to see how we might be able to help you out.

It may seem unusual to hear this, but we sincerely want to help investors. We want to show investors the good side of the financial industry. We believe that the best resources shouldn’t only be available to the wealthiest individuals. We created WMC with the vision of helping all Canadians gain access to the best financial resources in order to invest their money wisely based on informed decisions.

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