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Investment strategies: top down or bottom up?

There are many different ways that you can decide on what stocks to invest in. Most of the time, your selections will depend on your own unique investment objectives and risk appetite.

But there are still two broad investing styles that are worth keeping in mind when constructing your portfolio: the “top down” and “bottom up” approaches.

Top down approach

If you follow the “top down” approach, you will look at how patterns in the broader economy might increase the returns generated by certain industries or business segments.

For instance, you might look at the fact that Australia has an ageing population. Research has suggested that by 2056 some 22% of the Australian population is expected to be aged 65 and over. Based on this information, you would then think about companies that you believe might be able to capitalise on this shift in demographics. You might decide that aged care providers like Estia Health Ltd (ASX:EHE), Japara Healthcare Ltd (ASX:JHC) or Regis Healthcare Ltd (ASX:REG) could be worth investing in.

Or you might believe electric cars are the way of the future. As recently as September 2017, Bloomberg reported that annual electric vehicle sales are forecast to exceed 24 million by 2030, with most of that demand coming from China and the US. This could motivate you to invest in miners like Orocobre Limited (ASX:ORE) or Galaxy Resources Limited (ASX:GXY), both of which produce lithium, a key ingredient in the batteries required for electric vehicles.

Another trend that has gotten investors excited recently is the increasing global acceptance of the medicinal, and even recreational, use of cannabis. If you also believe that this industry can take off, you might look at the key Australian companies operating in this space, like Cann Group Ltd (ASX:CAN) or Auscann Group Holdings Ltd (ASX:AC8).

Or maybe you’ve spotted something in the economy no one is even aware of yet, and that is what’s going to guide your investing decisions.

The point is that, if you take a top down approach, you first look at the bigger picture. Then you narrow your search to specific stocks that you believe are best positioned to take advantage of those broader industry and economic trends.

Bottom up approach

If you follow the bottom up approach, broader economic trends won’t factor too much into your thinking when you’re selecting stocks. Instead, you’ll start at the individual company level and seek out firms that have performed well regardless of what industry they’re in.

For example, if you were a bottom up investor you might select growth companies like Ltd (ASX:KGN), Altium Limited (ASX:ALU) or Cochlear Limited (ASX:COH), not because of the particular industry segments they operate in, but simply because they have all delivered strong financial results.

Or you may have specific investment goals in mind that guide your decisions. You may decide to target high dividend yield companies like Telstra Corporation Ltd (ASX:TLS) or the big four banks for your portfolio as you might be concerned primarily with generating income.

However you define strong performance, you’ll look for these attributes in the stocks you select, ahead of any thoughts about patterns in the broader economy.

Foolish takeaway:

Neither of these approaches is necessarily better than the other. But it is worth thinking about both when you invest.

Looking at a company’s fundamentals and its recent financial performance is always going to be of prime importance when you’re considering buying its shares. But it’s also worth taking a step back to consider the broader picture, especially if you’re a long term investor seeking companies with strong growth potential.

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Motley Fool contributor Rhys Brock owns shares of AUSCANN FPO, Cochlear Ltd., Galaxy Resources Limited, and ltd. The Motley Fool Australia owns shares of and has recommended Telstra Limited. The Motley Fool Australia owns shares of Altium. The Motley Fool Australia has recommended Cochlear Ltd. and ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.