A beginners guide to… top-down vs. bottom-up investing styles

When deciding where and how to invest, two kinds of investment styles are most widely known, top down investing and bottom up investing.

What are these?

The top-down style is an approach which looks at the wider macroeconomic picture. This basically means looking at potential investments using a more global perspective, asking questions like, ‘How will this world event affect my investment?’

Looking at macroeconomic factors and using these to decide where or what to invest in, means you look at the large scale general economic factors which are effecting economies across the world to pick the investment you think will be best for you.

To understand this concept, it helps to compare top-down to bottom-up. A bottom-up investor is more concerned about individual companies and their performances, remaining less concerned about the outside influences such as interest rates, geopolitical risks and currency problems, which are usually all included under the banner of ‘macro’ issues.

Put simply, top-down is looking at the broader picture, such as the effects of economic conditions on whole industries and sectors, and deciding where to invest based on which areas they think are likely to be affected.

Here are some of the factors that individual and institutional investors may consider with a ‘top-down’ approach: –

• The effect that interest rates will have on an economy. Is the central bank of a particular country considering raising or lowering rates? What impact will that have on stocks? For example, bank stocks tend to benefit from higher interest rates, so this may be a factor to consider.
• The effect of geopolitical circumstances like war, sanctions and other factors which affect international relationships. How will these affect certain industries? Perhaps if a country is rapidly developing its military, defence stocks may be a wise decision for the prudent investor.
• The overall strength of an economy. For example, if European growth is lacklustre, while Asian markets are booming, the investor may consider the latter a better investment opportunity for the long term.

Conversely, the bottom-up style mainly sidelines those wider issues, and focuses on choosing stocks based on the characteristics of the individual company. However – they do not ignore the macroeconomic picture completely. Every kind of investment is linked to the wider economy, no matter how much it seems to be independent of it.

These investors may ask questions like: –

• How has this firm performed over time?
• Does it have good prospects?
• Does it have good management?
• How does it compare to it’s rivals?
• Does the company have the ability to identify new markets overseas which may have a lot of potential for the business?

This investor wants to find a company that’s going to remain strong regardless of what’s happening in the wider markets. They don’t necessarily pick a stock based on what sector it’s in or what’s happening to that sector as a whole, they have more of a laser focus on the business itself and its viability.

Let’s imagine a scenario. There is a large storm brewing in a town, with high winds that could damage properties. In this situation, a top-down investor is more interested in looking at the effects of the storm itself. Where is it moving? What other parts of the area is it likely to affect? What will the long term ramifications? The bottom-up investor meanwhile is looking at the strength of the individual buildings during the storm. They want to know about their individual house (stock investment for example). Does their house (investment) have a strong foundation (fundamentals) that can weather the storm? Will it still be there and have people living in it (buying its goods) even when the storm is raging?

The type of approach that an individual or fund will use to find the best investment also depends on which type of asset class they are considering. For example, in commodity investing, the value of these instruments is almost entirely dependent on macroeconomic factors (top-down). The price of gold is strongly correlated with geopolitical risk, as this precious metal is considered to be a ‘safe haven’ investment, which investors may look to invest in during times of volatility in the financial markets. The price of other metals like copper can depend on the prosperity of countries which depend on it for manufacturing and construction, like China. A slowdown in the Chinese economy may put downward pressure on metals prices, as they are building less, and by extension have less need for these materials. Overall, it is only really when investors are considering buying stocks that they have the choice to take either a bottom-up or top-down approach.

Remember…

• Past performance of an investment is no guide to its performance in the future.
• Investments, or income from them, can go down as well as up.
• Risk can be brought about by the performance of world markets, interest rates, taxes on income and capital, and foreign exchange rates.
• You may not necessarily get back any of the amount you invested.
• Smaller company shares can be relatively illiquid, meaning they could be harder to trade, which makes them higher risk.
• Content and information about potential investments are designed for general use, and so cannot be considered personal to your circumstances or your financial position.
• Don’t drink and invest at the same time!