There are many ways to find investment opportunities. Short-term traders often use technical analysis to find statistical options. Long-term investors often use fundamental analysis to find undervalued companies.
There are also many subsets of technical and fundamental analysis, such as the use of chart patterns when using technical analysis. You can take a bottom-up or top-down approach in fundamental analysis.
- No single approach to investing is right for all investors.
- Most top-down investors focus on large trends through exchange-traded funds (ETFs).
- Bottom-up investors tend to screen for stock attributes such as P/E ratios.
- You can invest with a top-down and bottom-up approach simultaneously.
Using a top-down investing approach would involve starting your analysis by looking at macroeconomic factors before working your way down to single stocks. You might look at what countries have the fastest growing economies. You might then look at individual sectors within these countries to find the best options.
Then you'll look at companies within these sectors before actually making an investment decision. You might look at other macroeconomic factors as well, such as economic or business cycles.
Most top-down investors are macroeconomic investors who are focused on capitalizing on large trends using exchange-traded funds (ETFs) rather than individual equities. They tend to have higher turnover than bottom-up investors. They’re more focused on market cycles than individual stocks. Their plan is more about momentum and short-term gains than any kind of value-based approach to finding undervalued companies.
Top-down investors benefit from access to a diversified portfolio of assets within a given country, region, or sector. They use funds for exposure.
The greatest drawback with top-down investing is that you'll have relatively little control over the ultimate makeup of your portfolio unless you invest in individual equities or bonds. Your portfolio may also have concentration risks if you're focused on countries or sectors rather than diversification.
Investors using a bottom-up approach start by looking at individual companies. They then build a portfolio based on their attributes.
A bottom-up investor might screen for stocks trading with a low price earnings (P/E) ratio. They would then review companies that meet that criterion. They'll take a deeper look at each one that comes up on the screener. They'll evaluate them based on other criteria. The investor may also rely on external factors for added insight, such as reading analyst research reports and opinions.
Most bottom-up investors are microeconomic investors that focus on attributes of a company when they're building their portfolio. They tend to be buy-and-hold investors. They invest a lot of time researching stocks rather than the environment surrounding these stocks. This means that their investments may take a longer time to play out. But it could be more effective at managing risk. They could increase risk-adjusted returns in the end.
Bottom-up investors benefit from portfolios that are often well-diversified in terms of industry and geography. They know that every component of their portfolio meets their investment goals.
The downside to this type of investing is that underlying attributes they’re screening for must produce above-market returns for them to be successful. It’s possible that low P/E ratios alone will not outperform the S&P 500 benchmark index over the long run.
The Best Approach
No single approach is right for all investors. The decision between top-down or bottom-up investing is largely a matter of personal preference. But these two styles aren't mutually exclusive.
You can combine top-down and bottom-up investing when building a diversified portfolio. You might start with a top-down approach and look for a country that’s likely to see rapid growth over the coming year or two. Then you might take a bottom-up approach within that country by looking for certain investments, such as companies with low price earnings ratios or high yields.
The key to successfully using these techniques is pinning down the correct criteria and analyzing them in a wider context. It could be due to a larger macroeconomic risk factor, such as an upcoming election or conflict, if price earnings ratios are depressed in a certain country. Investors must think about all these factors when making decisions in order to avoid making any costly mistakes.