Photo courtesy Mediamodifier on Pixabay.
Individuals entering stock markets expect to earn good returns as the stock markets provide better returns than the fixed-income instruments over the longer term. There are a number of ways investors invest; while some may do thorough research, others may invest just on the basis of tips and the latter is not the correct way. For the safety of investment, a thorough analysis of the company or the sector in which the company operates has to be done, which will help to determine the future performance of the stock. There are two strategies commonly used by people and are called top-down and bottom-up investing.
Top-down investing-
Top-down investing focuses on the big picture which starts with the broader analysis and then moves to specific sectors. In this approach, the investors first identify the macroeconomic factors that have an impact on the market and then identify the sectors that would perform well under such factors. The next step is to filter down the stocks belonging to these sectors that are expected to perform well and where an investment can be made.
The top-down investment approach includes the study of the economic growth across the world or the growth in GDP of countries, the monetary policy of the US Federal Reserve Bank, inflation, and bond prices and yields. For example, a top-down investor may look at rising interest rates as an opportunity to invest in bank stocks when the banks can earn more revenue, as they can charge higher interest rates on the loans. In the same way, when investors believe that there is going to be a drop in interest rates they can invest in the home building industry which benefits from lower interest rates which lead to more sales of homes.
When the research shows that a particular sector will perform well in the future the top-down approach can be used to select stocks. As the sector is expected to do well there are chances that most of the companies in the sector will perform well. The chances of selecting stocks that will not perform well get reduced. The top-down investors may even invest in a country or region if it is expected to perform well.
Bottom-up investing-
The difference between top-down and bottom-up stock investing is that the latter is more stock-specific and economy and sector agnostic. The investor tends to pay more weight to the fundamentals of a stock, not worrying much about the market trends. They focus on how an individual company performs in a sector.
The analysts doing bottoms-up investing study factors like-
- The financial ratios like the price-earnings ratio, earning per share, ROE, ROCE, profit margins, etc.
- The prospects of the company’s products, revenue, and current and future expected earnings.
- Cash flow.
- The performance of the management of the company.
- The company’s products, market share, and the new products or services expected to be introduced to the market.
The bottom-up approach may many times disappoint in the short term but can reward the investors well in the long run if they have done good research and they may be able to find many multi-baggers. It signifies the aspect of the time spent in the market rather than timing the market.
It is for the individual investors to decide which strategy to deploy and this can depend on their risk tolerance and investment goals. They may choose the top-down or bottom-up approach or may even go with a hybrid model where they may use both styles to construct their portfolio. It depends on the preference of the individual and there is no right way or wrong way. The top-down approach can help the investor to select the sector and then they can use the bottom-up approach to select stocks in the sector expected to perform well.