The world of trading is a complex and multi-faceted one, and there are many different approaches to investing. In this blog post, we’ll go over two different types of investing: top-down and bottom-up, and see how you can use both modes to make the most of your trading.
Top-down investing
Top-down investing is an investment analysis approach that first analyses macroeconomic factors, such as GDP, employment, taxation and interest rates, before examining micro factors such as specific sectors or other companies. This approach prioritises macroeconomic, national, or market-level factors.
In the process of top-down investing, investors use macroeconomic variables such as GDP, trade balances, currency movements, inflation, interest rates, and other aspects of the larger economy. After looking at these big-picture global conditions, analysts next examine the general market conditions to identify high-performing sectors, industries, or regions within the macroeconomy. The goal of this process is to find industrial sectors that are forecast to outperform the market.
Based on these factors, top-down investors then allocate investments from efficient, diversified asset allocations, rather than by analysing and betting on specific companies. From this point, they further analyse the stocks of specific companies to choose potentially successful ones as investments, looking at a particular company’s fundamentals.
Individual assets are best analysed using a combination of technical and fundamental analysis, to determine relative and absolute valuation. You can find out more about technical analysis at our blog post here, and you can find out more about fundamental analysis at our blog post here.
Pros:
- Top-down investing can help investors use their time more efficiently, as it mostly depends on looking at large-scale economic aggregates and readily available public data, and involves choosing among relatively few broad regions or sectors as opposed to the entire universe of individual stocks
- Top-down investing may produce a more long-term or strategic portfolio
- A top-down approach can help investors diversify their portfolios among not only top sectors, but also leading foreign markets
Cons:
- Top-down investing may cause investors to miss out on a large number of potentially profitable opportunities by eliminating entire industrial sectors or countries from consideration, even companies that outperform the general market
- Top-down investing relies on extensive individual research into global markets- there are a lot of macroeconomic factors that are constantly changing, and if your research is wrong or outdated, you could miss out on big opportunities
Bottom-up investing
While top-down investing starts with macro factors and moves into micro factors, bottom-up investing works the opposite way; it focuses on the analysis of individual stocks and de-emphasises the significance of macroeconomic cycles and market cycles.
In bottom-up investing, the investor focuses their attention on a specific company and its fundamentals, rather than on the industry in which that company operates or on the greater economy as a whole. This approach assumes individual companies can do well even in an industry that is not performing, at least on a relative basis.
Most of the time, bottom-up investing does not stop at the individual firm level, although the individual firm level is where analysis begins, and where the most weight is given. Industry groups, economic sectors, markets and macroeconomic factors are brought into the overall analysis, but as the name suggests, bottom-up investing starts its analysis from the bottom and works up in scale.
Bottom-up investors usually employ long-term, buy-and-hold strategies that rely strongly on fundamental analysis. This is because a bottom-up approach to investing gives an investor a deeper understanding of a single company and its stock, providing insight into an investment’s long-term potential for growth.
Pros:
- A bottom-up approach may lead to more tactical, actively-managed strategies
- Bottom-up investing allows an individual to become very familiar with a business in which they plan to invest capital, which can help make more informed decisions
- Bottom-up investing helps you identify companies that are outperforming the market; an outstanding company can grow even when general conditions are unfavourable.
- There are fewer factors to consider in a bottom-down analysis, making it less intensive than top-down analysis
Cons:
- A bottom-up approach may cause you to overlook important macroeconomic factors that can impact a company’s performance
- Trying to identify individual companies that will grow, or stocks that will rise in one sector, is tricky compared to looking at larger trends
- Bottom-up investing is harder for new or inexperienced investors; investors with little experience may find it difficult to shortlist a company to invest in for a short-term perspective.