Top-Down vs. Bottom-Up Investing: Which is better?

If you are interested in financial investments, you should already know that investments are all about planned strategies. It's not that dissimilar to a game of chess. There are a few methods and tactics in investing that may help you make winning movements from the start, much as there are in chess with Sicilian Defenses and Queen's Gambits.

 

The top-down and bottom-up techniques for investing in shares are two incredibly essential approaches. Making incorrect selections might ruin your investment portfolio. Choosing the appropriate approach is a critical decision for ensuring your future.

 

We'll finally put an end to the top-down vs. bottom-up investment argument in this blog by delving into each technique in depth.

 

Top-Down Approach:

 

Top-down investing, also known as top-down analysis, is a macro-level strategy for investing in which a fund manager examines the country's economic, social, cultural, and political conditions to identify any patterns or characteristics that might define the development of certain sectors.

 

What factors do analysts take into account when calculating predicted returns on assets such as stocks, bonds, real estate, and commodities? Factors at a high level, such as:

 

• Gross Domestic Product (GDP) 

• The direction and amount of interest rates

• The current level of unemployment in the economy.

• Future inflation expectations, for example.

• The region's political climate

 

Top-down investing has a simple logic: if macroeconomic variables are beneficial for a single sector or the whole market, the moment may be perfect to invest in a specific company.

 

Let's imagine you're debating whether or not it's a smart idea to buy stock in a solar panel company. 

 

You do a top-down investigation and discover that the renewable energy sector is expanding, solar panels are getting more popular, and governments all over the globe are promoting renewable energy in different ways. All of these characteristics might indicate that investing in that solar panel firm is a good idea – at least from a top-down perspective.

 

Some examples of the Top-Down Approach:

 

1. Bank stocks and Interest Rates:

 

Take a look at the graph below:

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A top-down approach with correlating the 10-year Treasury yield to the Financial Select Sector SPDR ETF (XLF) between 2017 and 2018 (source)

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Rising interest rates and bond yields may present an opportunity for a top-down investor to invest in bank equities. When long-term yields rise while the economy is doing well, banks often generate more money because they can charge higher interest rates on their loans. The relationship between interest rates and bank stocks, on the other hand, is not necessarily good. The economy as a whole must be doing well as yields climb.

 

2. Interest Rates & Home Builders:

 

Assume, on the other hand, that you believe interest rates will fall. Using the top-down method, you may conclude that lower rates would help the homebuilding business the most, as lower rates could lead to an increase in new house purchases. As a consequence, you can consider purchasing stocks in the homebuilding industry.

 

3. Stocks & Commodities:

 

If the price of a commodity rises, top-down research may focus on buying oil company stocks such as Exxon Mobil (XOM). A top-down investor, on the other hand, would think about how rising oil costs can damage a company's profitability if it uses a lot of it to create its product. The top-down method begins with the macroeconomy and then digs down to a specific sector and the stocks that make up that sector.

 

Thus, we conclude that wealth managers utilize this approach to assist them to discover the asset classes, sectors, and markets that they anticipate will outperform the market throughout the projected period. Wealth managers that are pursuing a tactical asset allocation strategy rather than one that focuses on individual securities choices will benefit from the top-down approach.

 

Also Read | Differences Between Stocks & Bonds

 

Advantages of the Top-Down Investing:

 

Here are some advantages of Top-Down Investing:

 

• This technique teaches you how global economic forces affect the stock market and how to examine this impact by focusing on macro variables.

 

• It broadens your horizons and allows you to think about investing prospects in different industries, economies, and countries.

 

• Top-down investing does not necessitate a deep understanding of finance or the stock market.

 

Disadvantages of Top-Down Investing:

 

Like advantages, the Top-down approach has some disadvantages as well, here are some of them:

 

• The method may cause an investor to ignore key distinctions between businesses and investments. When some sectors, for example, are doing well, not every firm thrives.

 

• Markets are not always predictable. Indicators may point to a specific outcome, but this isn't always the case.

 

• The area requires further research. The macro elements are numerous and complicated, and they are continually changing.

 

Who uses the Top-Down Approach?

 

Top-down investment is preferred by exchange-traded fund (ETF) managers because they have the resources to do comprehensive macroeconomic analysis and want to optimize their long-term profits. As a result, when you invest in an ETF, you are employing the top-down method of investing.

 

Because most macroeconomic patterns that Top-down focuses on are reasonably straightforward to see and anticipate, its substantial research basis allows little opportunity for mistake.

 

This makes it ideal for first-time investors who want to be secure and construct a diverse portfolio of assets across industries while still focusing on long-term gains.

 

The Bottom-Up Approach:

 

The bottom-up method is founded on the idea that excellent businesses can produce wealth even in sluggish markets and when the economy is struggling. It's the polar opposite of the Top-Down strategy.

 

In this strategy, the fund manager examines individual companies based on market performance, focusing on aspects such as corporate management, price-to-earnings ratios, and other related characteristics. 

 

The following are some of the areas where bottom-up analysis is focused:

 

• The price-to-earnings (P/E) ratio, current ratio, return on equity, and net profit margin are all financial ratios.

• Earnings growth, including predicted earnings in the future

• Growth in revenue and sales

• An examination of a company's financial statements, including the balance sheet, income statement, and cash flow statement.

• Cash flow and free cash flow are indicators of a company's ability to produce cash and support operations without incurring further debt.

• The company's management team's leadership and performance

• The goods, market domination, and market share of a corporation are all important factors to consider.

 

These investors think that if a firm seems to be strong, it will continue to do well over time, regardless of how the general market performs. They will pay little regard to market circumstances or industry fundamentals, instead of focusing on how one firm in a sector performs in comparison to another to choose the stock they feel has the best chance of increasing in value. 

 

Bottom-up investment is the most hands-on, analytical method of the two, requiring the investor to do extensive research on the firm before making a decision.

 

Outperforming Stocks:

 

Bottom-up investors also feel that just because one firm in a sector does well does not indicate the industry as a whole will. These investors seek certain firms in a sector that will outperform the competition. That's why bottom-up investors devote so much effort to researching a business.

 

Because analysts generally have extensive knowledge of the firms they cover, bottom-up investors often analyze research papers that analysts put out on a company. The theory behind this strategy is that individual stocks in a sector can do well despite bad industry or macroeconomic performance.

 

What defines a good outlook, on the other hand, is a matter of opinion. A bottom-up investor evaluates businesses and makes investments based on their fundamentals. The business cycle, as well as larger industry circumstances, are unimportant.

 

Let's imagine you've seen an up-and-coming, buzz-worthy tech firm and are debating whether or not to invest in it. You use the bottom-up strategy to do your investigation and learn that the company's leadership seems to be bright and strategic. Within its industry, the firm has a sizable market share, its stock price has doubled in the last year, and its profits per share are respectable. However, you observe that the company's stock has an exceptionally high P/E ratio, implying that the firm's price is much greater than its Earnings Per Share. You investigate more and discover that the stock's P/E ratio is greater than that of its industry's nearest rivals.

 

You arrive at the following two conclusions:

 

• The stock is expensive, which means that its price may fall in the future.

• Investors are prepared to take this risk because they believe the company's revenue will rise, causing the share price to rise as well.

 

As a consequence, investing in this firm at the time of your bottom-up study may be speculative, leaving you to decide whether you want to risk it or put your money elsewhere.

 

Advantages of Bottom-Up Investing:

 

Some advantages of the Bottom-Up investing approach are given below:

 

• The method assists you in identifying firms that outperform the market. Even when the overall environment is negative, a great firm can expand.

• It requires you to examine every facet of possible investment and seek weaknesses.

• It's ideal for short-term projects. Even if a company's long-term prospects seem dim, it can nonetheless do successfully.

 

Also Read | Difference between Saving and Investing

 

Disadvantages of Bottom-Up Investing:

 

Here are some disadvantages of Bottom-Up Investing:

 

• You may be unable to diversify your portfolio if you place too much emphasis on individual firms or industries.

• It is necessary to have some theoretical understanding of how financial markets and instruments work.

• In certain circumstances, this might lead to entirely speculative investments.

 

Who uses the Bottom-Down Approach?

 

Because the bottom-up strategy is based on short-term or real-life data, it is best suited to short-term, profit-driven investments, making it a favorite among seasoned individual investors.

 

We don't always imply speculating when we say "short-term investments." However, because the financial variables that this technique evaluates fluctuate often, the bottom-up approach typically demands investors to move quickly.

 

If you've previously attempted the top-down technique, developed a diversified portfolio, and gained some understanding of how markets function, bottom-up investing is the way to go. As a result, it might be a terrific method to add more risk and, ultimately, greater return to your portfolio.

 

Also Read | What is Passive Portfolio Management?

 

Top-Down vs. Bottom-Up Investing:

 

The top-down strategy, in general, starts with a high-level view of the global economy. Following that, it narrows its focus to specific asset classes and worldwide sectors. Meanwhile, the bottom-up method begins with particular and progresses to a broader picture of the economy.

 

When making economic projections, most portfolio managers find it beneficial to use both methodologies. 

 

Why? 

 

Most of the time, these two techniques result in wildly divergent outlooks for the markets they profess to represent.

 

For example, some have argued that the bottom-up investment technique has been excessively enthusiastic at times during market peaks. At the same time, at market troughs or bottoms, they're too pessimistic. 

 

The most common criticism leveled against top-down analysis is that it focuses on extrapolating recent events while attempting to forecast the future. 

 

What's the issue? 

 

This increases the danger of investors being caught off guard by unanticipated external economic shocks.

 

Conciliating top-down and bottom-up projections might be a useful exercise for analysts and wealth managers in this regard. It enables them to have a deeper understanding of the market's underlying consensus. It also gives a clearer idea of the reasoning behind any differences between the two techniques.

 

Also Read | What is Trading?

 

 

Conclusion:

 

Let's go back and address the main question: which approach will bring you more money after we've looked at both investing strategies. Both are short and rather paradoxical answers.

 

Even though the top-down vs. bottom-up investing discussion may get heated, both strategies can be extensions of the same investment philosophy. Combining the two strategies is not unusual among investors. Some people begin by developing their portfolios from the top-down, accumulating a diversified range of secure assets before moving on to the bottom-up technique to locate more specialized investment opportunities.