Understanding of Top-Down, Bottom-Up Approaches to Investing
There are various approaches to investing in equities but the question is — 1. Which is the most appropriate way to pick a stock? 2. What is the best approach to use? & 3.When should it be used?
When it comes to investing, there is no one-size-fits-all strategy or approach that is the most optimal for all investors. Assessing both internal and external factors requires skill. Decide which investment strategy works best at that time.
The Top-down and Bottom-up approaches, however, may not be easy to grasp for beginners. So, in this blog, we are going to discuss the two most prominent investment approaches- The Top-Down Approach and the Bottom-Up Approach.
Read to find out the meaning of these approaches and investing strategies which will help you to hone your stock market investment skills.
TOP-DOWN APPROACH
A macro-level approach of investing, the Top-Down investing approach means analyzing the big picture, economic factors to make an investment decision. In this method, a fund manager looks at the social, economic, cultural and political situation of the country to decide if any of these factors can impact the growth of certain sectors.
Next, for a particular sector, the fund manager analyzes the performance of various companies in that particular sector and picks out the stocks that have a bright future. In other words, Top-Down investors focus on the macro-economic environment before choosing the stocks.
This strategy aims at exploiting the opportunities that follow market cycles. One starts with analyzing the macros and then goes down to micros. The goal is to pick stocks that will outperform general economic trends.
The technical aspect is to first analyze the market trend, followed by the sector trend and finally the trend of the stocks.
However, the major drawback of Top-Down Investing is that one has minimum control over the final portfolio that will be prepared by using this method unless you invest in equities and bonds. Also, if one has focused more on countries and sectors and not on diversification, one may face concentration risks.
BOTTOM-UP APPROACH
Under the Bottom-Up approach, the main focus lies on local or company-specific variables and gradually expands to other factors. This strategy looks at the stock triggers, right away. The starting point of analysis is the company. The underlying idea in this approach is that good companies generally help in creating good wealth, even when the markets and economy are not performing well.
In the case of several companies, they offer great results when the overall market scenario was not very appealing. This approach is more stock-specific as compared to the Top-Down Approach.
Unlike the Top-Down Approach, in the Bottom Up approach, one looks at the stocks first, followed by the sector trends and finally the market trends. One can look for stocks trading with a low price-earnings (P/E) ratio while picking stocks using this approach of investing.
Other factors while using this approach include Current Ratio, Return on Equity, Net Profit Margin, Revenue Growth, Leadership and Performance, Cash Flow statements, Financial Statements and Market Share among others.
Microeconomic factors that emphasized attributes of the company are more important in this approach. Plenty of time is required to research stocks, rather than the markets in which those stocks are traded.
One has to perform thorough research about the past performance of the company, historical data, and other related aspects of the company.
TOP-DOWN VS. BOTTOM-UP APPROACHES
The basic difference between the Top-Down and Bottom-Up Approaches is-
- Top-Down Approach goes from the general to specific and;
- Bottom-Up Approach starts at specific and moves to general.
While the Top-Down approach focuses more on macro variables, the emphasis in the Bottom-Up approach is on the narrow variables. Both approaches are not mutually exclusive and have striking differences, but are sometimes used adjacent to one another.
The question about which approach must be used and at what time does not have a clear answer. It completely depends on the objectives of the investor and the anticipated time in a trade. In common cases of short-term trading, the Bottom-Up approach gets the green flag.
FINAL WORDS
To sum up, stock market investors must understand that no single approach is right for all investors. The ultimate decision is mainly a matter of personal preference. One can combine Top-Down and Bottom-Up approaches while building a diverse portfolio. The best practice to adopt is by assessing the correct criteria and analysing them in a wider context.
Both approaches work differently in a unique set of circumstances. Thus, both methods should be applied in tandem by fund investment managers, so that they make better decisions. Also, investors must consider all the factors while making decisions to avoid any investment mistakes.
