Is it time to buy stocks in times of intense fear and volatility? Part 3: Stock picking approaches

October 29th, 2008

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Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position,

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick?

Broadly speaking, there are two approaches to stock-picking: (1) top-down and (2) bottom-up.

The bottom-up approach is, as we explained in Confidence back? Beware of bear market rally,

… invest in businesses based mainly on its individual merits and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

The last few articles of our guide, Value investing for dummies, will elaborate more on the basics of the bottom-up approach. If you want to utilise the bottom-up approach, please understand that it has a major weak point, as we explained in Should value investors be ?bullish? in a bear market?:

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses.

The top-down approach is to start off by looking at the broad macroeconomic themes and then zoom into individual businesses that may benefit from those themes. An example of such approach is to look at the broad macroeconomic implications of rising long-term energy prices (see How to profit from rising energy prices?) and then study the merits of investing in oil companies and alternative energy developers.

This approach has intuitive appeal because of human tendency to seek out a story. Macroeconomic themes are always expressed in the form of stories. But you must be aware that due to your human weaknesses, the appeal of stories can cause you to fall into narrative fallacies (see Mental pitfall: Narrative Fallacy). In addition, a superficial understanding of stories tend to lead one to oversimplify the thought process of picking stocks based on macroeconomic themes. For example, just because commodity prices is in a very long-run secular up-trend does not mean that any mining stocks will be good long-term investments (see Rising metals price=rising mining profits? Think again!)- there are much more subtleties involved.

In the next article, we will talk about the bottom-up approach by continuing on the incomplete series at Value investing for dummies.

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