Top-Down vs. Bottom-Up: An Overview
Top-down and bottom-up approaches are methods used to analyze and choose securities. However, the terms also appear in many other areas of business, finance, investing, and economics. While the two schemes are common terms, many investors get them confused or don't fully understand the differences between the approaches.
Each approach can be quite simple — the top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general. These methods are possible approaches for a wide range of endeavors, such as goal setting, budgeting, and forecasting. In the financial world, analysts or whole companies may be tasked with focusing on one over the other, so understanding the nuances of both is important.
Key Takeaways
- Top-down usually encompasses a vast universe of macro variables while bottom-up is more narrowly focused.
- Top-down investing strategies typically focus on exploiting opportunities that follow market cycles.
- Bottom-up approaches start with local or company-specific variables and then expand outward.
- Fundamental analysis is an example of a bottom-up investment approach.
- While top-down and bottom-up are distinctly different, they are often used in conjunction with one another.
Top-Down
Top-down analysis generally refers to using comprehensive factors as a basis for decision-making. Thetop-down approachseeks to identify the big picture and all of its components. These components are usually the driving force for the end goal.
Top-down is commonly associated with the word "macro" or macroeconomics. Macroeconomics itself is an area of economics that looks at the biggest factors affecting the economy as a whole. These factors often include things like the federal funds rate, unemployment rates, global and country-specific gross domestic product, and inflation rates.
An analyst seeking a top-down perspective wants to look at how systematic factors affect an outcome. In corporate finance, this can mean understanding how big-picture trends are affecting the entire industry. In budgeting, goal setting, and forecasting, the same concept can also apply to understand and manage the macro factors.
Top-Down Investing
In the investing world, top-down investors or investment strategies focus on the macroeconomic environment and cycle. These types of investors usually want to balance consumer discretionary investing against staples depending on the current economy. Historically, discretionary stocks are known to follow economic cycles, with consumers buying more discretionary goods and services in expansions and less in contractions.
Consumer staples tend to offer viable investment opportunities through all types of economic cycles since they include goods and services that remain in demand regardless of the economy’s movement. When an economy is expanding, discretionary overweight can be relied on to produce returns. Alternatively, when an economy is contracting or in a recession, top-down investors usually overweight safe havens like consumer staples.
Investment management firms and investment managers can focus an entire investment strategy on top-down management that identifies investment trading opportunities purely based on top-down macroeconomic variables. These funds can have a global or domestic focus, which also increases the complexity of the scope.
Typically, these funds are called macro funds. They make portfolio decisions by looking at global, then country-level economics. They further refine the view to a particular sector, and then to the individual companies within that sector.
Top-down investing strategies typically focus on profiting from opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
Bottom-Up
The bottom-upanalysis takes a completely different approach. Generally, the bottom-up approach focuses its analysis on specific characteristics and micro attributes of an individual stock. In bottom-up investing concentration is on business-by-business or sector-by-sector fundamentals. This analysis seeks to identify profitable opportunities through the idiosyncrasies of a company’s attributes and its valuations in comparison to the market.
Bottom-up investing begins its research at the company level but does not stop there. These analyses weigh company fundamentals heavily but also look at the sector, and microeconomic factors as well. As such,bottom-up investingcan be somewhat broad across an entire industry or laser-focused on identifying key attributes.
Bottom-Up Investors
Most often, bottom-up investors are buy-and-hold investors who have a deep understanding of a company's fundamentals. Fund managers may also use a bottom-up methodology.
For example, a portfolio team may be tasked with a bottom-up investing approach within a specified sector like technology. They are required to find the best investments using a fundamental approach that identifies the companies with the best fundamental ratios or industry-leading attributes. They would then investigate those stocks in regard to macro and global influences.
Metric-focused smart-beta index funds are another example of bottom-up investing. Funds like the AAM S&P 500 High Dividend Value ETF (SPDV) and the Schwab Fundamental U.S. Large Company Index ETF (FNDX) focus on specific fundamental bottom-up attributes that are expected to be key performance drivers.
When to Use Both Approaches
Generally, while top-down and bottom-up can be very distinctly different both are often used in all types offinancial approacheslike checks and balances. For example, while a top-down investment fund might primarily focus on investing according to macro trends, it will still look at the fundamentals of its investments before making an investing decision.
Vice versa, while a bottom-up approach focuses on the fundamentals of investments, investors still want to consider systematic effects on individual holdings before making a decision.
What Is the Main Difference Between a Top-Down and Bottom-Up Approach?
A top-down approach starts with the broader economy, analyzes themacroeconomicfactors, andtargetsspecific industries that performwell against the economic backdrop. From there, thetop-down investor selectscompanies 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 moremicroeconomicfactors. Both approaches are valid and should be considered when designing a balancedinvestment portfolio.
Which Is Easier: Top-Down or Bottom Up Investing?
Top-down investing is often easier for new investors who are less experienced at reading a company's financial statements and for those who don't have the time toanalyzethose financials.
What Is a Limitation of a Top-Down Approach?
A top-down approach is more generalized, and so may miss out on a number of potentially good opportunities by eliminating specific companies that don't fall into its criteria.
The Bottom Line
Top-down analysis begins at the macro level, looking at things like national economic data (e.g., GDP or unemployment) and then homing in on more micro variables. A bottom-up approach is the opposite, beginning micro (e.g. looking at a single company's financial statements) and then broadening out. In the end, there is no single best approach to investing, and every approach has its own pros and cons. A robust strategy is to employ features from both top-down and bottom-up together.
