While performing the fundamental analysis of companies, two of the most common strategies to research stocks that are used by investors are top down and bottom up approach.
In this post, you’ll learn what exactly is top down and bottom up approach, how they work and which one may be more suitable to you.
Top down approach
Have you ever heard any investor/analyst saying something like- “The electric vehicle industry looks particularly promising now. The industry is growing at a fast pace and I should invest in this industry”.
Well, here the investor is following the top down approach to find stocks.
In the top down approach, the investors first look into the macro picture of the economy and later work down to research the individual stocks.
The overall steps involved in top down approach is to first look at the big picture of the world i.e. which economy is doing great, then look at the general market in that economy, next find the particular sector that may outperform and finally research the best stock opportunity to invest within that sector.
For example, let’s say you studied that the European economy is growing at a very fast rate. Next, when you looked further into the European market, you found that especially the biotechnology industry in outperforming. And finally, you researched some appealing stocks in that industry to invest. This is the top down approach for stock investing.
Here, you start with the big picture and ultimately move down to find the suitable investing opportunity. Top down approach looks at the performance of the economy & sector and believes that if the industry is doing good– the chances are that the stocks in that industry will perform too.
A few of the major areas where the top down analysts pay attention are economic growth, GDP, monetary policy, inflation, prices of commodities, bond yields etc before moving into the specific industry study.
The biggest advantage of top down approach is that there’s no pre-conceived notion about what may work and the selection of economy, industry & stocks are based on the real-time studies. Further, as they focuses on the strong sectors, the chances of underlying companies performing well are favorable.
However, one of the major flaw of top down approach is that here you may miss out a few good bargain stocks in the eliminated industries.
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Bottom up approach
This approach is exact opposite of the top down approach. Here, you first start with company research and later move up to find the other details.
Bottom up approach tries to study the fundamental of the company regardless the market conditions, industry or the macroeconomic factors. While performing the bottom up approach, the investors studies how fundamentally strong the company is by focusing on its revenues, earnings, financial ratios, products/services, sales growth, management etc.
The key here is to find the potentially strong company which may outperform the industry and market in future. If the fundamental factors are good, then regardless of what the industry is doing, the bottom up investors will pick such companies to invest.
The biggest advantage of the bottom up approach is that the investors may find the best potentially strong company which can outperform even if the economy or industry as a whole declines. Bottom up approach helps in picking quality stocks.
On the other hand, one of the cons of bottom up approach is that the investor may have some pre-conceived notion of the company and in such condition, their investment decisions may be a little biased. Further, as these investors ignore the longer economic influence and market conditions, some investment returns may be adversely affected because of these factors.
Top down and bottom up are entirely different approaches to analyze and invest in stocks. However, both have their own advantages and disadvantages.
The top down approach first looks at the broader economy and macroeconomic factors, and then move to the specific industry and the company within. On the other hand, bottom up approach starts at the company level and later moves up for the other important details.
In general, top down approach can be little easier for the less experienced investors as they do not have to perform the intense stock research and analysis. They can start studying the most appealing industry and find the companies within to invest.
Anyways, both approaches have their own effectiveness and hence, difficult to say which one is better. Moreover, it also depends on the knowledge and preference of the investor. My final advice would be to better try out both the approaches and find out which one suits you the best for your investment strategy.
Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting