There are thousands of stocks to choose from in the stock market.

How on earth do you decide which ones to pick?

In fact, ever wondered how your mutual fund manager goes about it?

Read on to get an insight.

There are basically two types of investing styles: top-down investing and bottom-up investing. Depending on how they pick their stocks, investors fall into one of these categories.

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Top-down

Top-down investors first analyse the 'big picture', the broad trends in the economy, sometimes even the global economy.

For instance, a top-down investor in the US could argue that growth in China and India will be much higher than growth in the rest of the world. He could then decide to invest in the Chinese and Indian markets.

His next decision would have to be whether that growth would best come about by investing in multinational corporations that operate in these countries, for example Coca Cola or IBM, or by investing in local Indian and Chinese companies.

If he decides on the latter, he would have to decide how much to allocate to India or to China, taking into account the relative potential of each market.

If he decides on a country, say India, he will then decide which sectors he should invest in. He may decide that there is huge potential in the growth of consumer credit (consumer loans) in this country, which means he should invest in the banking sector. 

Finally, he would look at individual stock valuations in the banking and financial sector to decide which of them he would include in his portfolio. That's the top-down approach.

Let's say that real estate rates are low, interest rates are slated to drop and consumer spending is on the rise.

As a top-down investor, you would look at how this would impact the economy.

This would translate into a real estate and probably even a retail boom. This means construction will start booming and malls and department stores will begin to spring up across the country. It will impact certain sectors like housing finance, the cement industry, the ceramics industry, sanitary suppliers and the glass industry, to name a few.

Now, within these industries, selections will be made for the right companies.

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Bottom-up

In contrast, the bottom-up approach concentrates on finding good bargains at the individual stock level; the sector doesn't really matter.

As long as the companies are strong, the business cycle or broader industry conditions don't matter to the bottom-up investor.

A bottom-up investor, for example, would comb through the financial results of individual companies, look at their track record, perhaps even talk with their management, and compare their relative valuations and growth prospects before deciding where to invest.

Sandip Sabharwal, head of equity, SBI [Get Quote] Mutual Fund, says his approach has been largely bottom up.

He gives an example.

"We were one of the first investors in the automobile sector. After meeting a whole lot of auto companies in early 2002, I realised all these companies had undergone substantial restructuring over the previous five years and were seeing significant volume growth.

"My key picks at that time were Mahindra & Mahindra at around Rs 100 per share and Tata Motors [Get Quote] at around Rs 75 per share.

"My position in these two stocks based on bottom-up research finally led me to the same result as a top-down positive view on the auto sector." 

To look at the entire interview, read Investing is an art, not a science.

The top-down approach is a bird's eye view, while the bottom-up approach is a worm's eye view.

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Which one is better?

Both the styles are useful, and they go in and out of fashion.

In recent years, foreign investors have re-discovered India and the India growth story has been sold well abroad, thanks to our strengths in outsourcing, our IT companies, our auto ancillary companies, our attraction as a low-cost, high quality destination for MNCs, and our high rate of economic growth.

The result has been a much higher allocation to India-dedicated funds (foreign based private and mutual funds that invest only in India). In short, it's the macro story that is driving investment into India.

However, the Indian stock market has always been known as a bottom-up market, with good companies in every sector and, equally, bad companies in each sector.

While bottom-up investing is far more painstaking and detailed, it has the advantage of being able to discover nuggets that may have been overlooked by the broad-sweep of the top-down style.

The risk is that too much attention on one company or industry could isolate the investor from getting the broader picture.

To take one example, while an individual FMCG company may be doing well, a decline in rural incomes may hit it hard. A bottom-up investor may fail to take that into account. Or a change in economic policy may deal a blow to fertiliser companies.

On the other hand, bottom-up investing tends to be immune to fads and fashions and can be applied to any market or sector, regardless of the prevailing investment trend.

By looking for stocks that are basically sound, investors can insulate themselves from the gyrations of the market.

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The best of both worlds

As always, what works is not a pure top-down or bottom- up approach, but a combination of the two.

As Sanjay Prakash, CEO, HSBC Asset Management Company, says, "Once we have chosen our sectors from a top-down perspective, we then focus on bottom-up stock picking within each sector." 

Any investor worth his salt will never work only on one approach.

Even if his selection is based on the bottom-up strategy, he will keep an eye on the overall economy and business cycles to decide whether or not to stay with the stock or sell.

A stock analyst put it succinctly, "At times, despite a stock having great fundamentals, you need an overall change to unlock its value."

For instance, take the Securitisation Bill passed in Parliament in 2002. The government's decision boosted the banking sector and bank stocks became hot picks.

This bill helped banks deal with the thorny issue of non-performing assets. Under the Securitisation Bill, as far as overdue loans were concerned, banks could take the help of the metropolitan magistrate in seizing assets held as collateral without going through the costly and time-consuming legal process.

Certain public sector banks showed a tremendous surge in stock price due to this change.

And while it may be good to identify sectors with the greatest potential, one needs to keep in mind that not all companies in that sector will do well.

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All said and done, this drives home the point that investing is serious business.

Whatever approach you take (and I suggest you take both), you must do your groundwork before making that pick.

Only then will it truly pay off.