Bottom Up vs. Top Down Investing: What’s the Best Approach?
A Look at the Two Subsets of Fundamental Analysis
There are many different ways to find investment opportunities. On a high level, short-term traders often use technical analysis to find statistical opportunities and 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 or indicators when using technical analysis or taking a bottom-up or top-down approach in fundamental analysis.
Investors using a top-down investing approach start their analysis by looking at macroeconomic factors before working their way down to individual stocks.
For example, a top-down investor might start their analysis by looking at what countries have the fastest growing economies. Then, they might look at individual sectors within these economies to find the best opportunities. Finally, they will look at individual companies within these specific sectors before actually making an investment decision. The investor might also look at other macroeconomic factors as well, such as economic or business cycles.
Most top-down investors are macroeconomic investors 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 since they’re more focused on market cycles than individual stocks. This means that their strategy 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 since they use funds for exposure. The primary drawback is that they have relatively little control over the ultimate make-up of their portfolio unless they invest in individual equities or bonds. Their portfolio may also have concentration risks if they’re focused on specific countries or sectors rather than diversification.
Investors using a bottom-up approach start their analysis by looking at individual companies and then building a portfolio based on their specific attributes.
For example, a bottom-up investor might screen for stocks trading with a low price-earnings (P/E) ratio and then review companies that meet that specific criterion. Then, they will take a deeper look at each individual company that comes up on the screener and evaluate them based on other fundamental criteria. The investor may also rely on external factors, such as reading analyst research reports and opinions for added insight.
Most bottom-up investors are microeconomic investors that focus on specific attributes of a company when building their portfolio. They tend to be buy-and-hold investors since they invest a lot of time researching individual stocks rather than the environment surrounding these stocks. This means that their investments may take a longer time to play out, but could be more effective at managing risk and ultimately increasing risk-adjusted returns.
Bottom-up investors benefit from a portfolio that’s often well-diversified in terms of industry and geography and they know that every component of their portfolio meets their investment goals. The downside is that underlying attributes they’re screening for must produce above-market returns in order for them to be successful. For example, 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
There is no single approach that’s right for all investors and the decision between top-down or bottom-up investing is largely a matter of personal preference. But, it’s worth noting that these two investment styles are not mutually exclusive.
Many investors combine top-down and bottom-up investing when building a diversified portfolio. For example, an investor 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. They might then take a bottom-up approach within that country by looking for specific investments, such as companies with low price-earnings ratios or high yields.
The key to successfully using these techniques is identifying the correct criteria and analyzing them in a wider context. For instance, if price-earnings ratios are depressed in a specific country, it could be due to a larger macroeconomic risk factor, such as an upcoming election or conflict. Investors must carefully consider all of these factors when making investment decisions to avoid making any costly mistakes.