Understanding Top-Down Approach of Investing: When investing the money we always aim to pick the right stocks that can generate the maximum returns on your investments. To do so, different qualitative and quantitative analysis tools help you analyze stocks.
Two such tools are the “top-down” and the “bottom-up” approach of investing. In this article, we closer take a look at both the investing approaches with a particular focus on understanding the Top-down investing approach.
What is Top-Down Investing approach?
The top-down investing approach works like a funnel. It begins with taking a broad view of the market as a whole, narrowing down until a choice is made on the investment.
The top-down approach involves looking at the broad economic, demographic, and cultural changes in a country to identify the major themes and drivers which in turn will determine the growth and profitability of sectors. In other words, analysis of macro factors is the key determinant.
When using the top-down approach, we look at the macroeconomic factors, i.e choosing a country or multiple countries. Next, we move to the sectors or areas where we expect the market to perform. Finally, come down to the individual companies within those sectors which we believe would be outperforming.
In brief, investments are allocated at the macro level looking at the global markets, then to sectors and industries, and finally to individual companies.
Top Down Approach V/S Bottom up Approach
The top-down analysis approach starts by looking at the bigger picture or the macroeconomic factors in play. Therefore, before deciding on whether an investment is particularly beneficial, investors need to begin by studying the country’s GDP, inflation rates, rise and fall of interest rates.
The bottom-up approach takes a completely different perspective. Generally, the bottom-up approach focuses its analysis on specific characteristics and micro attributes of an individual stock. Bottom-up investing begins its research at the company level but does not stop there.
These analyses weigh company fundamentals heavily but also look at the sector, and microeconomic factors as well. Generally, a bottom-up strategy is commonly used by buy-and-hold investors who have a deep understanding of a company’s fundamentals. Fund managers may also use a bottom-up approach for managing passive funds.
Top-Down and Bottom-up Investing Example
Let’s take a real-life example to understand both approaches better.
An individual invests his capital in Indian Stocks, having a high weightage of his portfolio component in the metal & commodities sector. Here investment in the commodity sector as a whole and assigning a higher weightage in a particular sector is an example of top-down investing.
In the same way, if an investor believes specific stocks like Tata Steel or National Aluminium(NALCO) will benefit the most from the commodity price rise. Therefore he invests in these stocks irrespective of the other stocks in the same sector, then it is part of a bottom-up investing strategy.
What are the Macroeconomic Factors Relevant to Top Down Investments?
- Gross Domestic Product– The top down approach usually starts from the highest level by studying the country’s GDP.The growth in a country’s GDP and the future forecast of the GDP is the most important aspect of a top down strategy.
- Geopolitical risk – Before investing in a particular country investors will undertake research on the general political atmosphere in its location. Political unrest in a country can lead to immense stock market volatility, thereby exposing investors to the risk of losses. Thus, in top down investing, one looks for geopolitical stability in the region.
- Inflation– International investors must take into consideration the performance of the local currency before parking funds into designated stocks. While businesses can seem to be doing well in the local currency, conversion to an investor’s currency may reveal a not-so-impressive growth.
- Interest Rates– Changes in interest rates by the Federal Bank or changes monetary policies are also a deciding factor in the top down approach.
The Argument for Top-down investing Approach
As per a study conducted by Bank of America- Merrill Lynch using data of 1600 Indian Mutual fund schemes. The inference drawn from the study is that when the stock market is on an uptrend, a ‘bottom-up’ approach to stock picking works best, while in a weak market, a ‘top-down’ approach comes handy.
DSP Black Rock India Mutual fund also agrees to this argument by stating facts about their underperformance due to under-weightage in IT and Pharma stocks during the 2017-2018 period.
Advantages of Using Top-Down Approach
The top-Down Investing Approach brings with it multiple advantages. The most important however is the minimization of risk. Employing top-down analysis calls for a great deal of research. Not only do you have to compare the economies of different countries but also different sectors in the chosen state. This means that the likelihood of choosing a company that’s on a downward trend is low; hence, minimizing your risk of investment.
Another reason for using top-down analysis is that it allows you to diversify your investments across different sectors. You can even choose to diversify your portfolio across global markets. If you come across an international market that is performing well, you can allocate part of your capital to it. Diversification helps to lessen the blow in case the primary market you’ve invested in undergoes a downturn.
Since every top-down analysis begins with a global outlook of the economy, it’s highly unlikely for investors to be caught off-guard by upheavals. Ideally, this strategy requires that an investor keeps abreast of geopolitical issues and whole economies. Given the vast information such investors have regarding global events and interlaced networks, it’s easy to predict trends in different sectors.
A top-down investment method also uncovers instances where a large investment would not be appropriate for an investor’s portfolio. Thus, it prevents them from over-investing.
All these advantages support the fact that top-down analysis is worth considering. However, this is not to say that you should do away with the bottom-up strategy entirely. After all, you can use a combination of both strategies. With the bottom-up technique, you’ll have a clear picture of an individual firm before deciding to invest in it. This approach enables you to access the company’s financial reports to help you determine whether it has a solid financial position.
Risks of Using Top-Down Approach
A big risk that looms in the top-down approach is that the mutual fund’s management conclusion could turn out to be wrong. For instance, top fund managers across the globe had predicted a pickup in auto sales due to lower oil prices and invested heavily in auto and related sectors but that turned out to be a bad bet.
In a top-down approach, fund managers can select certain sectors which could make your portfolio less diversified and there could be an opportunity loss during a bull run. The approach also eliminates whole sectors from consideration, without accounting for the top companies under them. Stocks from such companies may be functioning quite well in the market.
Overall the top-down and bottom-up approach have their own advantages and disadvantages. While the top-down approach offers a bigger & overall perspective of the investment environment in a country, the bottom-up approach helps in factoring down to individual companies which have the growth potential and are trading at an attractive valuation.
There are various factors in each approach that suits some investors and vice versa. Choosing which investment style to use in your personal investments depends on what suits you best and the economic environment in place. As an investor, one must consider each of these factors before deciding whether top-down investing is suited to their style of investing.
No single approach to investments is without the accompanying advantages and flaws. In terms of the difference between top-down and bottom-up investing, it’s really two different paths that lead to roughly the same destination. Happy Investing!