Top-Down vs. Bottom-Up: What's the Difference? - Investopedia

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 ... TableofContents Expand TableofContents Overview Top-Down Bottom-Up WhenToUseBothApproaches FAQs TheBottomLine Budgeting&Savings Budgeting Top-Downvs.Bottom-Up:AnOverview Top-downandbottom-upapproachesaremethodsusedtoanalyzeandchoosesecurities.However,thetermsalsoappearinmanyotherareasofbusiness,finance,investing,andeconomics.Whilethetwoschemesarecommonterms,manyinvestorsgetthemconfusedordon'tfullyunderstandthedifferencesbetweentheapproaches. Eachapproachcanbequitesimple—thetop-downapproachgoesfromthegeneraltothespecific,andthebottom-upapproachbeginsatthespecificandmovestothegeneral.Thesemethodsarepossibleapproachesforawiderangeofendeavors,suchasgoalsetting,budgeting,andforecasting.Inthefinancialworld,analystsorwholecompaniesmaybetaskedwithfocusingononeovertheother,sounderstandingthenuancesofbothisimportant. KeyTakeaways Top-downusuallyencompassesavastuniverseofmacrovariableswhilebottom-upismorenarrowlyfocused.Top-downinvestingstrategiestypicallyfocusonexploitingopportunitiesthatfollowmarketcycles.Bottom-upapproachesstartwithlocalorcompany-specificvariablesandthenexpandoutward.Fundamentalanalysisisanexampleofabottom-upinvestmentapproach.Whiletop-downandbottom-uparedistinctlydifferent,theyareoftenusedinconjunctionwithoneanother. Top-Down Top-downanalysisgenerallyreferstousingcomprehensivefactorsasabasisfordecision-making.The top-downapproach seekstoidentifythebigpictureandallofitscomponents.Thesecomponentsareusuallythedrivingforcefortheendgoal. Top-downiscommonlyassociatedwiththeword"macro"ormacroeconomics.Macroeconomicsitselfisanareaofeconomicsthatlooksatthebiggestfactorsaffectingtheeconomyasawhole.Thesefactorsoftenincludethingslikethefederalfundsrate,unemploymentrates,globalandcountry-specificgrossdomesticproduct,andinflationrates. Ananalystseekingatop-downperspectivewantstolookathowsystematicfactorsaffectanoutcome.Incorporatefinance,thiscanmeanunderstandinghowbig-picturetrendsareaffectingtheentireindustry.Inbudgeting,goalsetting,andforecasting,thesameconceptcanalsoapplytounderstandandmanagethemacrofactors. Top-DownInvesting Intheinvestingworld,top-downinvestorsorinvestmentstrategiesfocusonthemacroeconomicenvironmentandcycle.Thesetypesofinvestorsusuallywanttobalanceconsumerdiscretionaryinvestingagainststaplesdependingonthecurrenteconomy.Historically,discretionarystocksareknowntofolloweconomiccycles,withconsumersbuyingmorediscretionarygoodsandservicesinexpansionsandlessincontractions. Consumerstaplestendtoofferviableinvestmentopportunitiesthroughalltypesofeconomiccyclessincetheyincludegoodsandservicesthatremainindemandregardlessoftheeconomy’smovement.Whenaneconomyisexpanding,discretionaryoverweightcanbereliedontoproducereturns.Alternatively,whenaneconomyiscontractingorinarecession,top-downinvestorsusuallyoverweightsafehavenslikeconsumerstaples. Investmentmanagementfirmsandinvestmentmanagerscanfocusanentireinvestmentstrategyontop-downmanagementthatidentifiesinvestmenttradingopportunitiespurelybasedontop-downmacroeconomicvariables.Thesefundscanhaveaglobalordomesticfocus,whichalsoincreasesthecomplexityofthescope. Typically,thesefundsarecalledmacrofunds.Theymakeportfoliodecisionsbylookingatglobal,thencountry-leveleconomics.Theyfurtherrefinetheviewtoaparticularsector,andthentotheindividualcompanieswithinthatsector. Top-downinvestingstrategiestypicallyfocusonprofitingfromopportunitiesthatfollowmarketcycleswhilebottom-upapproachesaremorefundamentalinnature. Bottom-Up Thebottom-up analysistakesacompletelydifferentapproach.Generally,thebottom-upapproachfocusesitsanalysisonspecificcharacteristicsandmicroattributesofanindividualstock.Inbottom-upinvestingconcentrationisonbusiness-by-businessorsector-by-sectorfundamentals.Thisanalysisseekstoidentifyprofitableopportunitiesthroughtheidiosyncrasiesofacompany’sattributesanditsvaluationsincomparisontothemarket. Bottom-upinvestingbeginsitsresearchatthecompanylevelbutdoesnotstopthere.Theseanalysesweighcompanyfundamentalsheavilybutalsolookatthesector,andmicroeconomicfactorsaswell.Assuch, bottom-upinvesting canbesomewhatbroadacrossanentireindustryorlaser-focusedonidentifyingkeyattributes. Bottom-UpInvestors Mostoften,bottom-upinvestorsarebuy-and-holdinvestorswhohaveadeepunderstandingofacompany'sfundamentals.Fundmanagersmayalsouseabottom-upmethodology. Forexample,aportfolioteammaybetaskedwithabottom-upinvestingapproachwithinaspecifiedsectorliketechnology.Theyarerequiredtofindthebestinvestmentsusingafundamentalapproachthatidentifiesthecompanieswiththebestfundamentalratiosorindustry-leadingattributes.Theywouldtheninvestigatethosestocksinregardtomacroandglobalinfluences. Metric-focusedsmart-betaindexfundsareanotherexampleofbottom-upinvesting.FundsliketheAAMS&P500HighDividendValueETF(SPDV)andtheSchwabFundamentalU.S.LargeCompanyIndexETF(FNDX)focusonspecificfundamentalbottom-upattributesthatareexpectedtobekeyperformancedrivers. WhenToUseBothApproaches Generally,whiletop-downandbottom-upcanbeverydistinctlydifferentbothareoftenusedinalltypesof financialapproaches likechecksandbalances.Forexample,whileatop-downinvestmentfundmightprimarilyfocusoninvestingaccordingtomacrotrends,itwillstilllookatthefundamentalsofitsinvestmentsbeforemakinganinvestingdecision. Viceversa,whileabottom-upapproachfocusesonthefundamentalsofinvestments,investorsstillwanttoconsidersystematiceffectsonindividualholdingsbeforemakingadecision. WhatIstheMainDifferenceBetweenaTop-DownandBottom-UpApproach? Atop-downapproachstartswiththebroadereconomy,analyzesthe macroeconomic factors,and targets specificindustriesthatperform wellagainsttheeconomicbackdrop.Fromthere,the top-downinvestorselects companieswithintheindustry.Abottom-upapproach,ontheotherhand,looksatthefundamentalandqualitativemetricsofmultiplecompaniesandpicksthecompanywiththebestprospectsforthefuture—themore microeconomic factors.Bothapproachesarevalidandshouldbeconsideredwhendesigningabalanced investmentportfolio. WhichIsEasier:Top-DownorBottomUpInvesting? Top-downinvestingisofteneasierfornewinvestorswhoarelessexperiencedatreadingacompany'sfinancialstatementsandforthosewhodon'thavethetimeto analyze thosefinancials. WhatIsaLimitationofaTop-DownApproach? Atop-downapproachismoregeneralized,andsomaymissoutonanumberofpotentiallygoodopportunitiesbyeliminatingspecificcompaniesthatdon'tfallintoitscriteria. TheBottomLine Top-downanalysisbeginsatthemacrolevel,lookingatthingslikenationaleconomicdata(e.g.,GDPorunemployment)andthenhominginonmoremicrovariables.Abottom-upapproachistheopposite,beginningmicro(e.g.lookingatasinglecompany'sfinancialstatements)andthenbroadeningout.Intheend,thereisnosinglebestapproachtoinvesting,andeveryapproachhasitsownprosandcons.Arobuststrategyistoemployfeaturesfrombothtop-downandbottom-uptogether. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. CharlesSchwab."FNDXSchwabFundamentalU.S.LargeCompanyIndexETF." AdvisorsAssetManagement."AAMS&P500HighDividendValueETF(NYSE:SPDV)." RelatedArticles Tools LearnHowTop-DownandBottom-UpInvestingDiffer InvestingBasics AreYouaBottom-UporTop-DownInvestor? TechnicalAnalysisBasicEducation TechnicalAnalysisStrategiesforBeginners InvestingBasics ATop-DownApproachtoInvesting Economics Microeconomicsvs.Macroeconomics:What’stheDifference? GuidetoMutualFunds AnalyzingMutualFundRisk PartnerLinks RelatedTerms WhatIsTop-DownInvesting? Top-downinvestingconsidersfirstmacro-leveleconomicorindustrydatabeforenarrowinginonmeso-andmicro-factorstomakeinvestmentdecisions. more Bottom-UpInvestingDefinition Bottom-upinvestingfocusesontheanalysisofindividualstocksandde-emphasizesthesignificanceofmacroeconomiccycles. more InvestmentAnalysis:TheKeytoSoundPortfolioManagementStrategy Investmentanalysisisresearchingandevaluatingastockorindustrytodeterminehowitislikelytoperformandwhetheritsuitsagiveninvestor. more TheBasicsofFinancialAnalysis Financialanalysisistheprocessofassessingspecificentitiestodeterminetheirsuitabilityforinvestment. more Fundamentals Fundamentalsconsistofthebasicqualitativeandquantitativeinformationthatunderliesacompanyorotherorganization'sfinancialandeconomicposition. more MacroeconomicsDefinition,History,andSchoolsofThought Macroeconomicsstudiesanoveralleconomyormarketsystem,itsbehaviors,thefactorsthatdriveit,andhowtoimproveitsperformance. more