If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for but a moment, you will recognize how truly foolish it is.

A stock’s takings yield is the inverse of its P / E proportion. Therefore a stock with a P / E ratio of twenty-five has a revenues yield of 4%, while a stock with a P / E proportion of 8 has a takings yield of 12.5%. In this fashion, 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 at last money to money operations. As such, they deserve to be judged by a single measure : the discounted cost of their future money flows. For that reason, a top down approach to investing is silly. Beginning your search by first deciding upon the kind of security or the industry is similar to a general chief deciding on a left handed or right handed pitcher before gauging every individual player. In both cases, the choice isn’t simply hasty ; it’s fake. Regardless of if pitching left handed is intrinsically better, the general chief isn’t comparing apples and oranges ; he is comparing pitchers. Whatever inherent advantage or drawback exists in a pitcher’s handedness can be reduced to a final worth ( e.g, run worth ). For that reason, a pitcher’s handedness is only one factor ( among many ) to be considered, not a binding choice to be made. The same’s true of the type of security. It is neither more required nor more logical for a backer to like all bonds over all stocks ( or all outlets over all banks ) than it is for a general executive to like all lefties over all righties. You need not decide whether stocks or bonds are fascinating ; you need simply resolve whether a specific stock or bond is sexy. Similarly , you need not decide whether the market is undervalued or overvalued ; you need simply identify a particular stock is undervalued.

If you are convinced it is, purchase it the market be damned! Obviously , the most shrewd approach to investing is to appraise every individual security re all others, and only to consider the kind of security insofar as it has effects on every individual analysis. A top down approach to investing is a needless barrier. Some awfully smart speculators have imposed it on themselves and beat it ; there’s no need for you to do the same.

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