There is more than one way to success. This is true in many arenas, and investing is no exception.
Two unique methodologies exist in the professional investing landscape: ‘Top-down’ and ‘Bottom Up’.
You don’t have to know how to perform them yourself in order to get some value in understanding them at a conceptual level. And you don’t need to utilize either directly to create a resilient investing strategy. But there are benefits to understanding them, even if you don’t implement them directly.
After reading this article, you should be better informed on:
- The different types of investment analysis and nuances of each
- How professional investors make investment decisions
- How to make portfolio decisions regardless of advanced analysis techniques
Fair warning: We do not recommend that you try to implement either of these strategies on your own.
What Is Top-Down Investing?
Top-down investing is a methodology of examining the broader economic landscape in an attempt to pinpoint investment opportunities. Top-down investors are like scientists who study the entire ecosystem of the forest (The Economy), rather than studying individual trees. (Individual Securities)
Understanding Top-Down Investing
Macroeconomic trends and indicators serve as a guide for top-down investors seeking to capitalize on investment opportunities.
They start by analyzing global economic trends and indicators such as:
- GDP growth
- Inflation rates
- Interest rates
- Debt
- Deficits
- Asset valuations
- Geopolitical news
- And more
They also study the fluctuations of each, the ratios, and the relationships between the shifting variables. They attempt to identify patterns of how shifting trends impact various asset prices and use that information to identify the assets that appear to be promising. Only then do they analyze and select specific securities that they believe appear poised for growth.
How Top-Down Investing Works
For instance, a top-down investor may start by examining the current state of the economy and determine that it’s in an expansion phase. Based on this, they identify the technology sector as one that typically performs well during economic booms.
The tech sector is quite large nowadays though, and it has subcategories. A top-down investor may identify a trend that seems positive for a specific subsector within the larger tech sector.
So, after meticulously examining the tech landscape, they may then begin to research the companies that they believe have the strongest market advantages. Then they may make an investment in the companies that they believe can harness the power of the broad economic forces at play.
Advantages of Top-Down Investing
Top-down investors may find an edge in a world where macroeconomic trends or indicators have fallen or risen outside of their usual recent range. They also do not limit themselves to just stocks. By taking a global approach, every asset category is at their disposal, which may be a broader scope than some other investors.
Top-down investors strive to use their analysis to guide them to which investments seem to have strong economic tailwinds and avoid the investments that seem to be facing the most headwinds.
If they are right in their analysis, they may be able to reap the rewards of assets that are poised for strong appreciation and guide them away from investments that they believe have high risks.
What Is Bottom-Up Investing?
Bottom-up investing is the reverse. Instead of starting with a broad view of the economy, bottom-up investors focus on individual companies first. They’re more like the scientists who study the nuances of individual plants (Individual Securities) and pay less attention to the broader ecosystem of the forest (The Economy).
They analyze a company’s finances, business model, competitive advantages, and growth prospects in an attempt to determine its intrinsic value. (the fundamentals of a company)
Another term for ‘Bottom-Up’ Investing is called Fundamental Analysis, popularized by Warren Buffet.
The goal is to identify stocks that are undervalued by the market and/or have the potential for long-term growth, regardless of broader economic conditions. Bottom-up investors rely on fundamental analysis and focus on company-specific factors rather than macroeconomic variables.
Understanding Bottom-Up Investing
Bottom-up investors are more concerned with microeconomic factors than macroeconomic ones. They dive deep into a company’s financial statements, examining revenue growth, profit margins, debt levels, and cash flows. This fundamental bottom-up analysis helps investors assess a company’s financial health, fair valuation, and build projections for future earning potential.
Bottom-up investors also look beyond the financial statements. They consider the company’s management team, its position in the market, and its ability to drive innovation. They sometimes do this analysis with dozens or even hundreds of companies, filtering out the ones that don’t meet their standards, and only buying the ones that fall within their criteria.
How Bottom-Up Investing Works
Imagine a bottom-up investor is researching the retail sector. They may start by screening for companies with strong sales growth, healthy profit margins, and low debt levels. They then research each company more thoroughly, looking at factors like its competitive position, brand loyalty, and potential for expansion.
If a company meets their criteria and appears undervalued or fairly valued relative to its future growth prospects, they may choose to invest in it, even if the broader retail sector is struggling.
Advantages of Bottom-Up Investing
What makes bottom-up investing so powerful is the possibility of uncovering hidden gems that the market has overlooked. By focusing on hard metrics like price-to-earnings and earnings-per-share ratios, investors may be able to stumble upon diamonds in the rough that the market has undervalued.
Those that are willing and able to determine true valuations of companies have a distinct advantage over those who simply buy companies regardless of valuation. Although valuations don’t always come into play in the short-run, they often can dictate the performance potential of an investment in the long-run.
Bottom-up investors can have an advantage over other investors because they can be months or even years ahead of the market on understanding a company’s fair valuation. If their analysis was correct, eventually the market will realize this, and begin buying the company at higher volumes than before, which can result in a profit for the early holders. That then becomes a profit opportunity for the astute bottom-up investor.
Bottom-up investors are free to craft a portfolio that is unhindered by sector or geographic constraints. By researching a company’s intrinsic strengths, investors have the potential to identify profitable investments, even when the economy or a given sector is sluggish.
Key Differences Between Top-Down Investing and Bottom-Up Investing
The key differences between these approaches at the core are Philosophy and Strategy.
Top-down investing begins with macroeconomic analysis, considering factors like global economic trends, interest rates, and political events to identify promising sectors or countries before selecting individual stocks within those areas. This approach focuses on the broader economic environment and its impact on markets.
Conversely, bottom-up investing prioritizes individual company analysis, emphasizing financial health, management quality, and competitive advantages without much regard to macroeconomic factors. Bottom-up investors believe that strong companies can perform well regardless of broader economic conditions, and they seek undervalued stocks through detailed fundamental analysis
Risk and Diversification
Risk is ever-present in investing. And risk-mitigation can be accomplished more than one way. Whichever approach is taken, doing it correctly is easier said than done.
Some top-down investors may attempt to spread the risk by diversifying across sectors and regions, which can help cushion the fall in case of market fluctuations. Other top-down investors avoid entire sectors and regions entirely, while focusing in on others. This has the potential to lead to outsized returns but can also leave them exposed when their timing is off or when other variables come into play that they did not foresee.
Investing from the bottom-up comes with its own unique set of risks. By NOT analyzing the economy, they can also fall victim to a poorly timed investment that was facing headwinds that they simply did not see. Similar to top-down investors, some bottom-up investors take a very concentrated approach rather than a diversified approach. This gives them the opportunity for out-sized returns, but it also leaves them exposed to higher downside potential and can cause them to miss out on other opportunities.
Both strategies can be done in a very risky way (Concentrated bets), and in more risk-averse ways (Diversification).
Both methods discussed in this article are MUCH easier said than done. Very few people are likely to ‘beat the market’ over the long run by taking either of these approaches. Broader market indexes have a lot of this analysis baked into the cake, and generally, the wisdom of the crowd is too strong to overcome.
Combining Top-Down and Bottom-Up Approaches
Picture this: a balanced investment portfolio that leverages the precision of bottom-up analysis and the bird’s-eye view of a top-down strategy. Sounds too good to be true? Not if you’re willing and able to adopt a hybrid approach.
Many investors have found that there are pros and cons of each approach. Combining the insights from a broad economic outlook with company-specific analysis allows you to maximize the pros and minimize the cons, IF you can do it correctly.
A Hybrid Approach
Most investors seek a resilient portfolio that has great upside potential with limited downside.
So how can investors effectively combine top-down and bottom-up approaches? In theory, they would use top-down analysis for asset allocation that factors in broad market trends, and bottom-up analysis for quality individual security selections. Again, easier said than done.
For instance, an investor might use macroeconomic factors to determine an appropriate mix of the various asset classes in their portfolio. Within the stock portion, they may then continue their top-down analysis to identify potentially attractive sectors and countries. Then, they would use their fundamental analysis (Bottom-up) skills to identify what they believe to be the highest-quality stocks within those categories.
How to Invest Without the Guidance of a Professional
For most people, we believe it’s best to stick to a simple, low-risk approach. While simple, that is not always easy.
In our experience, many people don’t know what they SHOULD do and what they SHOULD NOT do when managing their money. They also don’t know all the risks that exist, which ones they are most exposed to, and how to potentially avoid them.
With that said, we believe there are a few core principles to stick to:
- Assess Your Goals
- Assess Your Investment Horizon
- Assess Your Risk Tolerance
- Minimize Taxes and Fees
- Buy and Hold Quality Assets for the long run
- Stay Diversified Amongst Multiple Asset Classes and Sectors
- Keep Your Emotions Out of Your Decisions
- Stick to the Plan
- Stay Disciplined
Role of Financial Advisors
Financial Advisors act as guides helping people make appropriate decisions with their money. Most people don’t know how to execute on each of those core principles mentioned above, and that’s where a professional can help.
It is our view that it takes years or even decades of training to become experienced in the advanced analysis techniques of bottom-up and top-down investing. What we don’t want is for people to enter an arena that they are unprepared for, especially when they would be better served by just sticking to the basics.
For those who want to explore the benefits of advanced analysis, it may make sense to explore working with a financial advisor. Some financial advisors have access to teams of analysts who utilize a hybrid approach rather than simply subscribing to one philosophy and not the other. These professionals have the skills and resources to analyze investments from both a macro and micro perspective.
Final Thoughts
The debate between top-down vs bottom-up investing has been going on for decades. Both approaches have their merits and drawbacks, and neither is necessarily better than the other.
The key takeaways are:
- A hybrid approach may be best.
- In general, people are unlikely to succeed by taking either of these approaches directly.
- Some Financial Advisors can take advantage of both strategies.
For more information, schedule a no-obligation 15 minute assessment with our team.
Content in this material is intended for general information purposes only and should not be construed as specific investment advice or recommendations for any individual. Please contact your advisor with any questions or specific recommendations regarding your own circumstances. Asset allocation does not ensure a profit or protect against a loss. Investing involves risks, including possible loss of principal.
