How Does Top-Down and Bottom-Up Investing Differ?

One of the keys to successfully managing your investment portfolio is to use any number of investment analysis strategies. Investment analysis is a way you can evaluate different kinds of assets and securities, industries, trends, and sectors to help you determine the future performance of an asset. Doing so will help you figure out how well it will fit in with your investment goals. Two of these strategies are called top-down and bottom-up investing.

Top-down investing involves looking at big picture economic factors to make investment decisions, while bottom-up investing looks at company-specific fundamentals like financials, supply and demand, and the kinds of goods and services offered by a company. While there are advantages to both methodologies, both approaches have the same goal: To identify great stocks. Here's a review of the characteristics of both methods.

Top-Down

The top-down approach to investing focuses on the big picture, or how the overall economy and macroeconomic factors drive the markets and, ultimately, stock prices. They will also look at the performance of sectors or industries. These investors believe that if the sector is doing well, chances are, the stocks in those industries will also do well.

Top-down investment analysis includes:

• Economic growth or gross domestic product (GDP) both in the U.S. and across the globe
• Monetary policy by the Federal Reserve Bank including the lowering or raising of interest rates
• Inflation and the price of commodities
• Bond prices and yields including U.S. Treasuries

Bank Stocks & Interest Rates

Take a look at the chart below. It shows a top-down approach with correlating the 10-year Treasury yield to the Financial Select Sector SPDR ETF (XLF) between 2017 and 2018.

A top-down investor may look at rising interest rates and bond yields as an opportunity to invest in bank stocks. Typically, not always, when long-term yields rise and the economy is performing well, banks tend to earn more revenue since they can charge higher rates on their loans. However, the correlation of rates to bank stocks is not always positive. It's important that the overall economy is performing well while yields rise.

Home Builders & Interest Rates

Conversely, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the homebuilding industry would benefit the most from lower rates since lower rates might lead to a spike in new homes purchases. As a result, you might buy stocks of companies in the homebuilding sector.

Commodities & Stocks

If the price of a commodity such as oil rises, the top-down analysis might focus on buying stocks of oil companies like Exxon Mobil (XOM). Conversely, for companies that use large quantities of oil to make their product, a top-down investor might consider how rising oil prices might hurt the company's profits. At the onset, the top-down approach starts looking at the macroeconomy and then drills down to a particular sector and the stocks within that sector.

Countries & Regions

Top-down investors may also choose to invest in one country or region if its economy is doing well. For example, if the European economy is doing well, an investor might invest in European exchange-traded funds (ETFs), mutual funds, or stocks.

Bottom-Up

A money manager will examine the fundamentals of a stock regardless of market trends when using the bottom-up investing approach. They will focus less on market conditions, macroeconomic indicators, and industry fundamentals. Instead, the bottom-up approach focuses on how an individual company in a sector performs compared to specific companies within the sector.

Bottom-up analysis focus includes:

• Financial ratios including the price-to-earnings (P/E), current ratio, return on equity, and net profit margin
• Earnings growth including future expected earnings
• Revenue and sales growth
• Financial analysis of a company's financial statements including the balance sheet, income statement, and the cash flow statement
• Cash flow and free cash flow show how well a company generates cash and is able to fund its operations without adding more debt.
• The leadership and performance of the company's management team
• A company's products, market dominance, and market share

Outperforming Stocks

Bottom-up investors also believe that if one company in a sector does well, that does not mean all companies in that sector will also follow suit. These investors try to find the particular companies in a sector that will outperform the others. That’s why bottom-up investors spend so much time analyzing a company.

Bottom-up investors typically review research reports that analysts put out on a company since analysts often have intimate knowledge of the companies they cover. The idea behind this approach is that individual stocks in a sector may perform well, regardless of poor performance by the industry or macroeconomic factors.

However, what constitutes a good prospect, is a matter of opinion. A bottom-up investor will compare companies and invest in them based on their fundamentals. The business cycle or broader industry conditions are of little concern.

Which One Is Right For You?

Just like any other type of investment analysis strategy, there's no right answer to this question. Choosing the one for you depends primarily on your investment goals, your risk tolerance, as well as the method of analysis you prefer to use. You may choose to use one, or you may consider going with a hybrid—that is, bringing in elements of both to build and maintain your portfolio. You may use a top-down approach to start off with, but then switch to a bottom-up style of investing if you're looking to realign your portfolio. There really isn't no right way or wrong way to do it. As mentioned above, it's all about what feels right for you.

The Bottom Line

A top-down approach starts with the broader economy, analyzes the macroeconomic factors, and targets specific industries that perform well against the economic backdrop. From there, the top-down investor selects companies within the industry. A bottom-up approach, on the other hand, looks at the fundamental and qualitative metrics of multiple companies and picks the company with the best prospects for the future—the more microeconomic factors. Both approaches are valid and should be considered when designing a balanced investment portfolio.