Bottom-Up Investing Vs. Top-Down Investing
By: Rupesh Oli
Bottom-Up Investing
Introduction
Bottom-Up Investing is an investment approach wherein an investor de-emphasizes the significance of macroeconomic cycles and market cycles, rather focuses on the analysis of individual stocks. The microeconomic factors need to be considered when an investor adapts the bottom-up approach of investing whether it be the company’s financial statements, the products and services offered, the company’s overall financial health, the supply and demand; all these factors carry significance on their own.
Bottom-up Analysts are also referred to as fundamental analysts as they tend to consider the internal factors such as the company’s management and the personnel, planned strategic activities, and its performance over the years. They, then, incorporate their findings to determine whether the company’s stock is undervalued or overvalued relative to the rest of the stocks in the market. Thus, investors build their investment/trades based on the underlying fundamentals of the asset.
Bottom-up investors tend to buy specific stocks more often than the funds. It is because they’re not looking to invest in a particular sector, rather hunting to invest in a company. As the fund represents the overall industry/sector comprising various stocks, they are the ones disregarded by the bottom-up investors.
Example
Suppose, Mr. A is keen on analyzing the market trends and fond of the companies with strong fundamentals and tends to dive deeper into the company’s financial statements and the underlying ratios such as EPS, PE ratio, ROE, profitability ratios, etc. In such a case, he would not be afraid to take the risk and would not mind his capital depreciation impacted along with the occurrence of events.
If Mr. A is more interested in trading and the quick surge of his invested capital, it would be better for him to approach the bottom-up investing as he would disregard the macro factors, rather decide his upcoming investments based on the micro factors based on what the company’s fundamentals – the financials – depict.
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Order of Analysis
Unlike Top-Down investing, the company/firm is the starting point of the analysis as Bottom-Up investing adheres to the premise that good companies can lead to substantial returns even in the tepid markets and underperforming economies.
Advantages
- Rather than analyzing the macroeconomic factors, investors divest the majority of their time on analyzing the business or the company – the internal factors. As a result, they become extremely familiar with the particular business or company that they are planning to invest in. Such an increased insight about a company helps in the prediction of the future performance of stocks.
- Instead of diversifying the portfolio into varying funds, investors tend to enjoy significant dividends when they adopt the stock investments. Such dividends would leverage them exponentially over the haul.
- Microeconomic analysis of a company would help you in identifying the companies that are outperforming the market in the contemporary context or tends to outperform at a certain point in time.
- Bottom-up investing would urge you to identify the loophole or the potential flaws of the investment you are going to execute so that you could think twice before such an execution.
- Investors’ confidence will automatically surge as they would select the company with strong fundamentals.
- Inclusive of the strong company’s stocks, investors have better prospects for long-term returns and Return on Investment (ROI).
Disadvantages
- It is obvious that the bottom-up approach of investing overlooks the macroeconomic factors. However, they are the ones that have the potential to wipe out your investment in a matter of moments.
- Investors can fall prey to biases as they would prefer a particular company or the security that may lead to complications later on or even to losses if failed to perform the comprehensive analysis.
- Gauging a particular business or a company demands immense time and effort so that an investor would be able to research every aspect of the business. In some of the cases, it would require even months or years.
- Considered to be riskier as it ignores the larger industry or the sector trends. When the company lags sector average growth or the industry average, investors ought to align with the same stocks they selected, hindering them to diversify their asset portfolio.
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Top-Down Investing
Introduction
Top-Down Investing – the contrary of Bottom-Up Investing – is an investing approach wherein investors base their investment decision based on macroeconomic factors such as inflation rates, the country’s GDP, the rise and fall of interest rates, and so forth. The investors – afterward – base their analysis to predict how the stock market would perform in the upcoming days. It would help them determine where the particular stock has the potential to generate high ROI coping with the prevalent macroeconomic circumstances.
Investors need to look at the bigger picture before delving into any sort of investment when it comes to top-down investing. For instance, global trends. If the macroeconomic factors favor a certain industry or the sector, it might be signaling towards the time to enter that particular sector.
Top-Down Investing proceeds with the macro level by first analyzing the global market, then to sectors and industries, and ultimately the individual companies which is the exact opposite of Bottom-Up investing which begins by looking at individual company’s fundamentals and spreads out to further analysis, next at the sector or the industry level and then the global market conditions.
Example
Suppose, Mr. A wants to start investing and decides to do so in the stock market. Hunting out a quick way to diversify his portfolio and planning to invest for the long haul, Mr. A decided to go with the top-down investment approach.
Instead of going through hundreds of stocks and filtering out the best ones suitable to invest in, Mr. A would invest in an ETF (exchange-traded funds) – maybe 3 or 4 – that would incorporate several economies and sectors. Such an ETF could be inclusive of both the specific country’s ETFs or the ETF that comprises of several international stocks.
With the investment in the fewer of the funds considering macro-factors only, Mr. A has created a diversified and low-cost fund portfolio depicting the top-down investment strategy.
Order of Analysis
The very first order would be the macro analysis where you would study various factors such as GDP, political volatility, inflation rate, etc., then move towards the sector analysis wherein you would limit your study to sector-specific. For instance, if you decided to invest in a tech company once it fits out in the macro analysis, you would now be analyzing only the technology sector to get a comprehensive overview of that particular industry/sector. Ultimately, you would be doing the firm analysis where you would be assessing the potential of that particular company or the business.
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Advantages
- You would be compatible enough to analyze how the global economic factors impact the stock market which would strengthen your investment decision-making over the haul.
- It would push forth the investors to analyze the investment possibilities spreading across the sectors – the industries, markets, and the countries.
- You need not need to worry about being swayed by the latest news stories or the stock tips as you would have the overall plan to invest further sticking to what you planned before.
- The Top-Down investment approach would prevent investing in stocks where it tends to fulfill all the criteria but lags on the macro factors. It would be putting you on the safer side as you tend to eradicate such stocks where the overall market is on the declining trend.
- It encourages diversification as you would be diversifying your investments on varying sectors and top-foreign sectors rather than aligning to fewer stocks.
Disadvantages
- You might overlook individual investment opportunities as you tend to generalize the performance of the entire country or industry.
- Your investment decision might turn obsolete as sudden shifts in the economy possess the capability to render the strategy you opted for.
- If a certain company is doing well but doesn’t fit into the investment strategy that you opted for – based on your macroeconomic analysis, you could miss out on the potential profits.
- If you are just beginning out, you might face trouble analyzing the whole market. Thus, you ought to have the perseverance to learn the critical skills to base your analysis, which is indeed an advantage as well if perceived from another perspective.
Bottom-Up Investing vs. Top-Down Investing: Which One to Opt for?
Whether it be bottom-up investing or top-down investing, both approaches have their pros and cons. It is up to the investors on how they would use both the investing approaches for the inclusion of stocks in their portfolios. If an investor would like to adopt bottom-up investing, they would need to figure out the nitty-gritty of the company’s fundamentals – the financials. On the contrary, an investor would need to base their investment decision based on the macroeconomic factors – need to comprehend the bigger picture.
However, it would be better to diversify the portfolio with stocks consisting of bottom-up investing and top-down investing approaches. It is because, ultimately, your stock portfolio would consist of the stocks possessing the strong fundamentals on one hand, and the ones that would favor the economy as a whole. As a result, your potential losses would be minimized if the investing strategies that you opted for do not favor you in the long period. Risk minimization would be in your favor when incorporating both strategies. As an investor, you should not be relying solely upon either of the strategies, however, if acquired enough strategies on all the levels be it the company, sector, or the macro, ultimately, you would be compatible to deal with the uncertainty that might knock the door of your investment at any point of time.
From The Author:
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