Top-Down or Bottom-Up

Answer 1

When approaching investment decision making there are two common approaches that one can take. First there is the top-down approach which takes into account data about the macroeconomic environment, business cycles, and industry trends. Second there is the bottom-up approach that focuses more on individual companies and their relative merits when considering investment.

Both approaches can be considered equally valid; they just come at the problem of allocating investment capital from different directions. The main difference between these methodologies is the weight given to economic factors and the particular industry of a given stock.

First, let’s consider the top-down approach. Those who follow this discipline generally believe that the economy and the market, as well as the particular industry in question carry a lot of weight on the importance of investment decisions. They may use tools such as leading economic indicators, charts of past business cycles, industry reports and the like to decide which industry would be a good bet given all the relative data before deciding on which particular firms within that industry to invest in.

Those who follow a more bottom-up approach to investment decision making tend to be in search of particular characteristics in the companies or stocks they are evaluating. They may start by looking for companies with a certain P/E ratio or use some other criteria to flag potential investments. Then they analyze the fundamentals of that company or charts for that particular stock in order to aid in their decision. These bottom-up investors believe that they can find stocks that are undervalued regardless of what is happening in any particular industry or the wider world of markets and economies.

Either approach can be tackled by fundamental analysts or technical analysts. Also, as I’ve stated, neither is right or wrong. But the next time you hear an analyst talking about a top-down or bottom-up approach to portfolio management you’ll have some idea what they mean.