Originally published on May 29, 2017
The financial world is vast, and the number of investing strategies reflects that. Two broad categories for classifying investment styles is the top-down and the bottom-up approach. As the people who coin these terms are more concerned with clarity than creativity, it is easy to understand the difference between the two approaches.
Top-down investing is also known as macro-investing. The investor looks at the overall economic outlook and chooses sectors. It is a useful approach for choosing a specific country (if you are open to foreign stock investing), and it works well for asset classes like commodities and currencies. Currencies don't really have a bottom-up counterpart, anyway, because their value against other currencies is entirely based on macroeconomic factors.
Bottom-up investing, on the other hand, is asset picking. The investor chooses a company because of the company's financial situation or outlook, not the general economy or sector. This is most widely used for equity, but it can also be easily applied to corporate bonds, since they have a similar source of value (the company).
The main difference, then, is choosing stocks based on sector or company direction. A top-down investor (TDI) still looks at company financials, but he is more concerned with finding the right industry. Once an industry is identified, any solid company in that industry can be a good pick.
For the bottom-up investor (BUI), it is all about the individual company. It doesn't matter if the industry is struggling because the company is solid and can still outperform the market (and certainly a struggling industry) if it is the right company. Such an investor does not ignore macro trends, but she tends to put much more weight on the company than the industry.
Advantages and Disadvantages of Top Down Investing
One big advantage is that industries are broad, so it is easier to narrow down your first search criteria. You can look at the big details, like spending in a particular market, the expected exchange rates, and consumer sentiment. These are numbers published by public entities like governments and non-profit organisations. If there is a housing shortage, construction companies are likely poised to generate profits.
TDIs usually start globally, so they aren't caught off-guard by major upheaval. They tend to keep track of geopolitical issues and entire economies. Since they know a lot of global events and the interlaced connections, they will be able to find rising sectors in rising areas. By using macro factors, the portfolio is more likely to rise in general. They can also avoid risky areas, like regions often embroiled in violence.
Moreover, many fewer stocks there are to screen. By eliminating entire industries and countries, huge numbers of possible options fall out of consideration early in the process. Once a favourable industry is identified, there are usually only a few top companies that are worthy of investment.
The elimination of entire countries or industries right from the beginning, however, can be a big drawback. It means TDI will miss out on potential huge gains, simply because a company's sector is not doing as well as others. Many TDIs prefer the predictability brought by a solid industry, though, so they may not care if they are missing big gains in other sectors.
The outlook for a sector or economy can reverse quickly, though, so TDIs are likely to enter and exit trades more often. In the TD approach, companies are viewed as proxies for investing in a sector, so once the sector is eliminated, all the companies should be eliminated - this implies lots of buying and selling when sector trends change. Whether there is an advantage or disadvantage is a matter of personal investing taste.
Advantages and Disadvantages of Bottom-Up Investing
Since bottom-up investing tends to ignore macro factors at first, there is a huge number of stocks to pick from (in fact, every stock possible). That means it is less likely that BUIs will miss large, predictable gains in an underperforming sector. Some BUIs may actually prefer underperforming sectors if they are a value investor like Peter Lynch or Warren Buffett (see our article on value investing here). The great number of potential candidates can be overwhelming, and this is where stock screeners are a powerful tool - and yes, we have an article for stock screeners too.
Just because a sector is underperforming or is volatile does not disqualify it to BUIs. Volatility is a good opportunity for growth investors, but value investors can derive benefit from volatile markets, too. Once a BUI is adept at using a stock screener, s/he can quickly eliminate poor stocks and look for potential big gainers.
Since BUIs focus on a company, once a solid company is determined, there is usually not a quick turnaround. While TDIs might enter a market for a week on an uptrend then exit, a BUI with a long-term strategy will stick with the company through good and bad times. This is why BU is more conducive to value investing.
One big drawback to bottom-up investing, aside from the preliminarily large number of stocks, is outside influence. BUIs should certainly not ignore macro trends completely, but sifting through all the micro factors and the macro factors can be too much; hence many BUIs don't pay as close attention to macro trends as TDIs. That can lead to unexpected losses, especially if a BUI holds a company vulnerable to factors far outside the spotlight of media or the financial press.
To clarify, a good example is a mining company near the border of a country under constant violence - a BUI might miss the neighbouring country's political issues because s/he only focuses on the chosen company's host country. A TDI would know that region is under pressure and would avoid all companies with operations there, even if there were great value buys.
Another drawback is the possibility of overexposure to a particular market. If a BUI finds several stocks in a sector that are ideal, exposure is likely to increase, even in a bear market for that industry. TDIs would reduce or eliminate their exposure at any sign of decline, as they exit a sector as soon as it starts to become unviable as a TD candidate.
Is it possible to combine the two approaches?
Using the strict, technical definitions of the words, it is not possible to combine the two approaches. They are mutually exclusive if they are defined as "how one starts the stock finding process". However, using a looser definition, there are many ways to combine the two approaches. BUIs may choose between two stocks based on macro factors, and this can be construed as a combination of the two. On the other hand, a TDI may pick a particular macro factor, like a country of operation or industry, then ignore other macroeconomic factors. This could also be construed as a combination.
Is one better than the other?
If one is investing in an asset class that is highly correlated to macroeconomic factors (like currencies or government debt), then top-down is probably the best approach. These asset classes may not even have microeconomic components.
If the asset class is equity or fixed income, it depends on the investor's risk tolerance. By dumping the industry at the first sign of trouble, TDIs can keep their overall risk lower. Strong companies in well-performing sectors can fail, but they are certainly likely to be more stable - only a catastrophic event will probably cause their collapse. BUIs need to be mindful of the industry trends, because even strong companies can succumb to powerful negative trends. Furthermore, BUIs need to be careful about overexposure to a sector. Sentiment can move against a company faster than against an industry (case in point: United Airlines), so BUIs can suffer sudden losses more easily - this comes down to diversification and overexposure again.
Disclosure: Author and stakeholders of CityFALCON may have vested interest in the financial securities discussed in the article