Bottom-Up vs. Top-Down Investing: Differences and Benefits Explained
The world of investing can be quite overwhelming for newcomers. Not only do you have to keep track of various factors such as market trends, price movements, the economy (both local and international), past returns, and more, but you also have to match those with your own time horizon and risk appetite. All of the aforesaid factors need to be considered to find the investment instrument for your needs. Doing so would allow you to figure out if a particular investment will work for you or not. This entire process is known as investment analysis where you use multiple valuations to understand and analyze the market along with those of different firms, industries, and sectors. Professionals such as financial advisors compare different investment options based on their past returns, yield potential, market sentiments, etc. Based on the investment analysis the advisors accordingly invest their clients’ money. Say, for example, you wish to invest in a mutual fund. To do so, first, you should conduct an investment analysis of your short-listed mutual funds. Compare different mutual funds based on their returns, exit loads, asset allocation, standard deviation, expense ratios, portfolios, management style, Sharpe ratios, and more.
You can consider different investment analysis strategies to help you make better investment decisions. Some of the popular investment analysis strategies are technical analysis, fundamental analysis, bottom-up investing strategy, and top-down investing strategy. Though you can carry out investment analysis on your own, it is advisable to seek the services of a professional financial advisor who can guide you through the process. Since the financial needs and preferences of each investor differ, it is important that comprehensive investment analysis is carried out.
Herein, we will compare two investing analysis strategies: bottom-up and top-down investing approaches. Read on.
What is the top-down approach to investing?
In a top-down investing approach, first, the macro factors of the economy are examined before focusing on the micro factors. The macro factors include the Gross Domestic Product (GDP), employment, taxation, interest rates, etc., whereas specific sectors or companies (more specifically individual stocks) form the micro factors of an economy. In plain words, you would start from the top at the time by analyzing stocks, mutual funds, etc., to figure out the effect of economy-level factors on your investments’ performance. Based on your analysis, you can select the investments that you believe will benefit from these macro factors. Later on, you can move down to analyze minor factors such as companies, sectors, and industries.
There are several variables that you should consider at the time of conducting a top-down investing strategy such as the country’s GDP, unemployment rate, and inflation, interest rate trends, business cycles, the Federal Reserve Bank’s monetary policy, bond prices, and the performance of a particular industry and sector in relation to their competitors and previous years’ performance.
Primarily, the top-down investing strategy is used for mutual funds and exchange-traded funds (ETFs) by the investors. But investors can also use it for analyzing commodities, stocks, bonds, etc. Proponents of the top-down investing strategy hold that if a sector is performing well, given the prevalent macroeconomic conditions in the country, the company stocks will perform well too. For example, with a fall in the interest rates, people are more likely to take out loans to buy homes or cars, as loans become easier on the pocket. This will in turn boost the real estate and automobile industry, making it a favorable time to invest in the stocks of these sectors. Similarly, with an increase in the price of oil, the oil companies can make substantial profits however those firms that depend on oil for transportation and production, may suffer as the costs for these would increase and adversely affect their profits.
What is the bottom-up approach to investing?
Conversely to the top-down approach, the bottom-up investing strategy starts from the bottom wherein the stocks and individual companies are analyzed before moving up to macroeconomic factors. Herein, the investors first analyze the company’s performance, its core principles, and fundamentals, demand for a particular product, etc. Based on the results, a stock is selected for investment purposes. The focus here is on the companies and their stocks rather than conducting a study of the entire sector. For example, suppose there is a steady uptick in the demand for vegan meat. While a top-down investor may look to invest in several vegan meat-producing companies, a bottom-up investor, on the other hand, will focus on a specific company and study its performance. Based on his analysis of the company’s past returns and performance, he will decide whether to invest in the company’s stocks or not.
Simply put, bottom-up investors do not give much credence to the performance of the market or the industry. They solely focus on individual businesses. Hence, the bottom-up investing strategy will prove more fruitful in the case of stocks rather than mutual funds or ETFs.
At the time of executing the bottom-up investing strategy, do take care to pay attention to the company’s business fundamentals, leadership and history, balance sheet, cash flow, return on equity, etc., product and service portfolio, and liabilities and losses. You also need to factor in different financial ratios such as the debt-to-equity ratio, price-to-earnings (P/E) ratio, price-to-sales ratio, etc., and market opinion and speculation.
The crux of the matter here is that investors who follow the bottom-up investment strategy are not looking to invest in a particular sector. They are hunting for specific stocks they think will perform well. Thus, a bottom-up investor would be more inclined to buy specific stocks rather than invest in mutual or index funds. This is a time-consuming process as the investor will have to carefully analyze the fundamentals of every company that they wish to invest in as every company differs from the next. This is likely going to be a task that requires a lot of time and effort. On the bright side, investors who follow this approach can significantly reduce their risk, since they are likely to be sure of their decisions.
Which among bottom-up investing and top-down investing is better and why?
Depending on what kind of investor you are, you can make use of either strategy. There is no right or wrong approach here. That said, the top-down investing strategy is primarily used by experienced investors since it requires detailed research on a number of parameters such as GDP, the lowering or raising of interest rates, inflation, and commodity prices to figure out in which direction the stock market may be headed. This may be quite overwhelming for new or relatively less experienced investors. Contrarily, the bottom-up investment strategy can be relatively less complex as bottom-up investors focus on a company’s fundamentals to decide whether or not to invest in it which helps concentrate their research, making it a simpler exercise.
Whether an investor chooses a bottom-up or a top-down investing approach ultimately boils down to your investment horizon, financial goals and targets, kind of investments, etc. You do not have to choose one strategy and stick to it. You can combine both strategies and invest in several kinds of investments. Doing so will allow you to build a well-diversified portfolio as well as improve your returns and reduce the risk potential. For example, suppose you wish to invest in international stocks, you can first begin by using the bottom-up investing strategy to study a company’s business model, product portfolio, other fundamentals, etc. Next, you look at the country’s economy where the company operates. Analyze the various macroeconomic factors meticulously including the country’s taxation policies, prevalent inflation rate, interest rate trends, etc. This would help you get an idea of what could impact your investment returns. Also, unexpected events such as wars, pandemics, natural calamities, etc., can seriously impact a company’s stocks. By combining both strategies, you can make a well-informed decision about where to invest your money.
That said, there are some drawbacks to using bottom-up and top-down investing strategies. These are:
- The bottom-up investing method does not give an optimal performance measure at market highs and lows. Additionally, experts are of the opinion that the results of the bottom-up investment analysis at highs tend to be overly enthusiastic, while lows tend to veer on the cynical end.
- Speaking of the top-down investment approach, herein, some experts believe that there is an acute focus on the past, which may not be a reliable indicator of the future. Further, it may not factor in the occurrence of unexpected events in the coming future.
If you are new to the world of investing, do not be discouraged by the fact that you find these strategies hard to understand or implement. You may require time and experience to improve your analyzing skills. Moreover, you have the option of consulting with a professional who holds expertise when it comes to understanding how the market works and knows how to analyze companies. You can take their help in making investment decisions that match your financial goals. Further, the advisor can offer assistance in matters related to creating a budget, reducing your taxes, boosting your savings rate, and more.
You do not have to pick one strategy over the other when it comes to choosing between bottom-up or top-down investing strategy. You can use a combination of both these methods to create a diversified, low-risk portfolio that can withstand market volatility to a large degree. That said, you may need to devote time to building sufficient expertise in these strategies to use them to your advantage. You can also hire a professional financial advisor to help you make informed decisions with respect to your investments.
Learn about different investing strategies and how to execute them to figure out which investments would help you reach your specific financial goals. Use the free advisor match service to engage with a professional financial advisor or more, who can help you conduct an analysis of different investing strategies to create a well-diversified investment portfolio. Based on your requirements, the service matches you with 1-3 advisors suited to meet your financial needs and goals.