The top-down approach to investment
For a systematic approach to investing, there are two approaches that one may follow. The first approach, known as the ‘top-down approach,’ recommends starting with a capital allocation decision, then asset allocation and security selection. Capital allocation decision essentially involves considering the choice between investing in a risk-free asset and a risky portfolio. This is driven by the risk attitude of the concerned investor. The second choice is to identify the risky portfolio and the composition of the risky portfolio. This is known as an asset allocation decision. Finally, one has to go for security selection. For each asset class identified in the asset allocation stage, the security selection entails identifying the specific company’s stocks or bonds to invest in.
The bottom-up approach to investment
The bottom-up approach is where we first identify the specific instruments to invest in. Once the security selection is made, we have put the required money to invest into each of these instruments, and we get the weights of money allocated to each of the broader asset classes. This step is the asset allocation decision. Finally, knowing the proportion of the capital employed in risk-free assets combined with the balance employed in the risky portfolio gives the capital allocation decision made by the concerned investor.
Capital allocation decision and risk preferences
The capital allocation decision is determined by the capital available and the risk preference of the investors. There may be three types of investors: risk-loving, risk-neutral, and risk-averse. A person with a risk-loving attitude would prefer to allocate more in the risky portfolio than a risk-neutral person. Similarly, a risk-averse investor will usually invest a lesser proportion in the risky portfolio than the capital invested by a risk-neutral investor in the risky portfolio.
How do we assess risk preferences?
The risk preference of any investor could be captured through an investment questionnaire. The questionnaire provides questions where a respondent has to make a decision when confronted with different investment prospects or asset classes. In asset pricing, the risk aversion is modeled using the utility function. The utility function helps to capture the preferences of a decision-maker.
So, the right way to investment is?
There is no conclusive answer to that. Both the approaches of ‘top-down investment’ and ‘bottom-up investment have their pros and cons. Let us hold these ideas for a later post.
Disclaimer: The author contributed to this article in his personal capacity. The views and opinions expressed are his own and do not necessarily represent the views of the author’s employer. Any comments or suggestions for improvements are most welcome. Please leave your comments below.