Evaluating investment options and determining your risk/return profile can be challenging. And sometimes evaluating the method to use to can be just as tough as the analysis itself. Should you engage in top-down vs. bottom-up analysis?
To anyone getting started in the world of investing, it can seem overwhelmingly complex—to some, it may even seem daunting. Though there is a certain element of risk to investing, certified financial plannerTM professionals have developed a number of methods that aim to give their clients the best possible risk/return trade-offs using statistical analysis before recommending investment strategies. One method involves knowing when to apply a top-down vs. bottom-up analysis: both are useful under particular circumstances, and experienced financial planners rely on elements of both when managing their clients’ portfolios.
Simply put, the top-down approach involves the analysis of big-picture macroeconomic factors—including the gross domestic product of a particular country, its politics, and overarching trends within a given economic sector. On the other hand, the bottom-up approach involves looking at the specific details of particular securities—things like the price-to-earnings (PE) ratio, leadership structure, and company news. Understanding the fundamentals of top-down vs. bottom-up is critical to engaging with your financial advisor and building a coherent investment philosophy.
What does a top-down approach mean in investing?
The reason why global markets may seem random and arbitrary to a casual observer is because world events, by and large, are random and arbitrary. For example, there’s no way to tell what kind of a harvest a particular region is going to have from one year to the next, and thus it’s not always easy to tell how a company or market dependent on that harvest is going to perform. One option an investor can do is pay attention to world events, understand or anticipate their implications, and be ready to move (or perhaps not move) assets around. That’s where a top-down analysis comes in.
A top-down approach to analyzing securities involves tracking broad factors affecting the global economy and the macroenvironment. Another way to look at the top-down approach is going from broad to narrow in terms of market research factors.
Steps in a top-down analysis
In going from broad to narrow, the first step a financial advisor might take is to look at various countries or regions to determine where there are opportunities for economic growth. From there, one might select a particular sector, such as energy, that appears to be at least partially responsible for fueling its growth. The further along one goes in their analysis, the more factors there are to consider. Here’s a quick list of elements that might be involved in a top-down analysis:
- Public policy: Is there a policy proposal that will make it harder or easier for a company to do business?
- Market trends: Is there a type of product or service that seems to be trending?
- Supply and demand curves: Is there a short supply, or should we anticipate an increase in demand?
- Unemployment rates: Does a country or region’s unemployment rate suggest a robust or stagnant economy?
- Inflation rates: How does the value of a nation’s currency compare to those of other nations?
- Consumer confidence: How likely are consumers to purchase items they need (e.g., consumer staples) versus items they merely want (e.g., consumer discretionary)?
- Interest rates: How cost effective is it for a company in a certain country to borrow money?
In the broad realm of investment possibilities, opting for the top-down approach is a sensible place to start, as it offers an investor a logic-based means to narrow one’s focus. Of course, maintaining a broad focus is also an option, as might be the case when looking to invest in a particular currency or some other investment that is connected to a broad, slow-moving economic factor. But if an investor’s focus narrows to the point of looking at individual securities, it may make sense to switch to a bottom-up approach, which we will explore in more detail later on.
The advantages and downsides to using a top-down approach
Of course, no single investment strategy is bulletproof. Financial planners are constantly weighing risk versus potential returns and when circumstances merit a top-down vs. bottom-up approach. It is a continuous process that requires a disciplined approach.
The advantages of a top-down approach
Broadly speaking, a top-down perspective is advantageous in that it trains an investor to study and understand how geopolitical events and economic factors traditionally influence global markets. This is critical for any investor looking to graduate from gambling on the markets to smart, statistical, strategy-based investing.
In terms of investments themselves, using the top-down approach to select securities is generally considered less risky, as top-down usually leads an investor to select broad categories of “diversified” securities rather than high-risk, high-reward opportunities. For example, a top-down approach may lead an investor to judge that the American energy sector is doing well, and thus they determine that they’re better off investing in an exchange-traded fund (ETF) that comprises various American energy-based securities.
The downsides of a top-down approach
Investors relying on the top-down approach for their investment choices are more likely to pay attention to some of the broader, slower-moving elements affecting markets—elements such as economic growth within nations, currencies, and commodities. As such, top-down investors may be too broad in a sector when they would have benefited from investing directly in the market leader.
What is bottom-up analysis in investing?
If a top-down analysis involves moving from broad factors to narrower factors, a bottom-up analysis is the opposite: beginning with a specific company’s details and gradually exploring broader factors. Although this article’s central subject—“top-down vs. bottom-down analysis”—suggests the two as diametrically opposed, the truth is that they aren’t mutually exclusive. An investor can and should take both approaches when creating an investment philosophy.
Factors involved in a bottom-up approach
A bottom-up approach is similar to a top-down approach in that both involve looking at data: the difference is in what data you’re looking at. Rather than focusing on broad market factors, such as public policy or interest rates, an investor taking the bottom-up approach starts by looking at a specific company’s financials—including its PE ratio, its cash flow, and its dividend yield. Here are a few more factors that a bottom-up analyst would look at:
- Free cash flows
- Dividend policy and yield
- Sustainable competitive advantages
- Supply chain
- Annual reports
- Projected future earnings: Has the company routinely hit its projected earnings, and is it likely to continue this trend?
- Growth: What is the company’s growth rate, and is it likely to continue?
- Leadership: What is the track record of the company’s executive suite?
- Business risk such as lawsuits: Is the company currently embroiled in high-profile litigation that won’t be resolved soon?
The advantages of a bottom-up approach
A bottom-up approach may force an investor to sharpen their skills when it comes to analyzing financials—a critical element in selecting securities. Any investment requires a great deal of due diligence and study to understand the salient details.
One idea behind a bottom-up approach is to spot an opportunity that others might miss. For example, a bottom-up analysis may reveal that a company with a low stock price is poised to rise soon—an assumption one may be comfortable making after studying key financial details. In short, selecting securities based on a bottom-up approach is important for those looking for outsized returns given a perceived risk level.
The downsides of a bottom-up approach
Though there’s a big opportunity for returns, there’s also the potential for more risk when selecting securities from a bottom-up perspective. And just as one taking the top-down approach can miss out on all the critical minutiae within an industry or business, so can an investor reliant on the bottom-up approach be unpleasantly surprised by critical big-picture factors that a company has no control over. For example, it doesn’t matter how good a company’s financials are if shutdowns—imposed by, say, a global pandemic—make it impossible for the company to conduct business normally. Looking solely at one company’s financials without considering larger factors is a classic example of missing the forest for the trees.
Who uses bottom-up analysis for investments?
The truth is that anyone interested in investing should at least understand the fundamentals of bottom-up analysis so they may judge when it is prudent to apply it. Either a top-down or bottom-up approach can be used as part of a shorter-term strategy for returns or a long-term strategy for retirement: which one to lean on depends on market conditions.
When to consider applying a top-down approach
Investors often rely on a top-down approach to narrow down their options. For example, an investor is unlikely to invest in a company in an underperforming sector—and identifying which sectors are performing well or poorly is only possible when an investor first undertakes a top-down approach.
There are also certain circumstances under which a top-down approach makes more sense. In the midst of the COVID-19 pandemic, for example, which proved to be profoundly unpredictable for global markets, it might have been more prudent for an investor to make investment decisions based on broader factors that were least likely to change quickly.
When to consider applying a bottom-up approach
The top-down approach involves analyzing broad to narrow factors whereas the bottom-up approach involves going from narrow to broad. As such, it makes sense that the two would meet in the middle—that is, an investor applying both strategies simultaneously will eventually discover that the two approaches overlap. Once an investor has identified which broad factors they wish to look into—for example, a country or a sector—they will naturally want to move into specific securities or other investment opportunities within that country or sector.
Remember, just because a company operates in a certain sector doesn’t guarantee it will perform well or even that it will succeed; this is why it’s important to also look at financial statements and other bottom-up information when settling on an investment. However, selecting securities solely through the bottom-up approach may not be the best decision during volatile economic times.
It’s easy to discuss top-down vs. bottom-up analyses as opposites that an investor must choose between. However, they are actually different sides of the same coin. An investor is less likely to be successful if they apply only one strategy, ignoring the other. Rather, it’s important to understand both strategies to help build a smart, diversified portfolio. Better yet, understanding both approaches can help you more intelligently engage with your advisor so you may move forward together on a coherent investment strategy aligned with your financial goals.
There’s a lot of information on the internet about investing: so much, in fact, that it’s inevitable that some of it will be contradictory or obsolete. While any smart investor should educate themselves on strategies and other intricacies of investing, a certified financial plannerTM professional has the experience and expertise necessary to separate good information from the bad. They can correctly interpret how economic changes are likely to affect investment expectations and help an investor determine if it meets their specific investment goals.
North Texas Wealth Management is poised to help people of all levels of investment knowledge navigate the seemingly random world of investing. Our experienced certified financial plannerTM professionals understand the broad and narrow factors affecting global markets, and can create a customized strategy to help you build the portfolio suited to your circumstances, wealth-management goals, and investment philosophy. Reach out to us today to get started.