Top-down or bottom-up approach, which one to adopt?

In the world of investment, people talk of ‘top-down’ or ‘bottom-up’ approach to investing. The lay and novice investors are bewildered by this financial jargon as these terms are beyond their comprehension. So, here we first try to understand what these terms mean and then figure out how to decide which of these two approaches is more suitable in a given situation.

Basically, a top-down approach means that you start with the big picture and then come down to the details in a logical manner. This approach is usually adopted by foreign institutional investors and foreign portfolio investors that invest in different geographies as also domestic institutions that are looking at growth-oriented stocks for the long term, but domestic retail investors can also adopt this approach to their advantage.

To start with, the investors begin with the macroeconomic and geopolitical environment and zero in on countries, states and regions where the macroeconomic environment is good and geopolitical situation is stable. The macroeconomic data of the country indicates the health of the economy and the geopolitical situation provides an indication of the likelihood of any civil disturbance or armed conflict with neighbouring countries. If the macroeconomic and geopolitical indicators are positive, the investors then look out for industries and sectors that are currently on a growth trajectory and are expected to do well in future too. Once the sectors and industries are identified, the investors then search for frontline companies in these sectors and industries and invest in stocks that hold high growth potential over the long term.

In sharp contrast to this top-down approach, investors adopting the bottom up approach start at the micro level by first identifying stocks that hold promise of growth going forward. The evaluation of the stock is done on various fundamental parameters such as the financial performance of the company over the last 3-5 years, market share of the company, valuation of the stock as compared to its peers, quality of management, track record of the promoters, etc. If the company fares well on all these parameters, it is assumed that changes in business cycles and economic environment may not impact the company too much. This style of investing is usually preferred by investors who are looking for undervalued stocks that hold the promise of the value getting unlocked going forward.

It is evident from the above that there is no single investment style that will work for everyone and at all times. Therefore, the practical and prudent approach is to adopt a blend of both styles to make the most of the opportunities available in the market.