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Top Down vs. Bottom Up Stock Analysis

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A successful portfolio requires a consistent strategy for analyzing stocks (or any security). Successful investors create long-term goals and metrics to help them decide which stocks and funds to buy and sell. They think about how each stock or fund purchase fits into their broader analytical framework. Then and this is the most important part they stick to that way of assessing investment prospects.

Two common strategies for analyzing stocks are the top down and the bottom up approaches. Each will help you understand how you want to invest your money.

What Is Top Down Analysis?

Top down investors base their decisions on the environment in which stocks are bought and sold. They analyze macroeconomic data to determine trends and then choose assets they think will benefit from those trends. A top down investor might look at how a specific industry has been doing, for example, to decide whether they want to buy stock in companies that work in that field. Or they might wait for the Federal Reserve to announce an interest rate change before deciding whether to buy stock in a corporation that is interest-rate sensitive.

It’s very common for top down investors to focus on mutual funds and exchange traded funds rather than investing in specific stocks or commodities. Funds are built around large-scale trends, collecting a series of assets around a broader issue to track that bigger data point. For example, a fund might be built to track the price of precious metals or the biotechnology sector. This mirrors the way a top down investor looks at the market.

Common issues that a top down investor will consider tend to include:

  • National economic and monetary policy Factors such as tax rates, regulation, interest rates that will affect every company in a nation;
  • National economic and monetary performance A country’s GDP trend, stock market performance, rate of inflation and other broadly shared outcomes;
  • Industry and sector performance How a specific sector has performed compared to other industries and compared to previous years;

These and many more factors help top down investors decide where to put their money. From there, they make decisions about which specific assets or funds to purchase.

What Is Bottom Up Analysis?

Bottom up investors base their decisions on individual assets. They analyze the performance of a specific company and build their trades around the fundamentals of that asset.

While market-wide factors aren’t irrelevant, this investor generally chooses to invest around how they think a specific company will do. For example, if the technology sector has declined over the past year, a top down investor might avoid technology, choosing to focus on stronger industries. A bottom up investor, on the other hand, might still buy shares of a specific technology company that they think is poised for counter-cyclical growth.

A bottom up investor generally considers factors that include:

  • Business fundamentals The business plan, leadership, history and products or services of a company;
  • Financial ratios Factors such as the price-to-earnings ratio, price-to-sales ratio and the debt-to-equity ratio of a company;
  • Market analysis What Wall Street analysts are saying about the corporation from both a quantitative and qualitative standpoint;
  • Overall financials The company’s balance sheet, liabilities, cash flow, income statement and return on equity.

Overall, bottom up investors look for specific stocks they think will do well. They aren’t looking to invest in a sector. They’re looking to invest in a company. As a result, this investor will tend to buy specific stocks more often than funds.

Top Down vs. Bottom Up Analysis

While both top down and bottom up investors will do better by holding their investments, this is particularly true for bottom up investors. Individual stocks are volatile, and a company’s day-to-day stock price will reflect the emotions of the market as much as anything else. The best way to capture a company’s fundamental value is to hold its stock long enough for trends to outpace short-term fluctuations.

By contrast, top down investors have more built-in diversity with their portfolios. By investing in entire markets and sectors, they have a cross section of assets that comes with every purchase. Bottom up investors, by focusing on individual stocks, do not. This means that a bottom up investor needs to pay closer attention to ensuring that they diversify their purchases.

The Bottom Line

Top down stock analysis gauges the economic, monetary, regulatory and sometimes even political context of the broader market. Bottom up stock analysis weighs a specific corporation’s financial health, its commercial prospects and market share, for example. These two approaches need not be mutually exclusive. Successful investors whose analysis is primarily top down still must consider bottom up factors. Likewise, a primarily bottom up focus shouldn’t preclude top down considerations.

Tips
  • Consider talking to a financial advisor about which type of stock analysis is best for you. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • The bottom up vs. top down framework is not the only consideration in choosing an investment strategy. Among other factors to consider are value or growth or income investing. There is also the question of whether an investor wants active or passive investing. When it comes to building a position in the market, few strategies are as consistently successful as long-term investing. Here’s how to do that and why it works.

Photo credit: iStock.com/fizkes, iStock.com/LTzido, iStock.com/Avalon_Studio

The post Top Down vs. Bottom Up Stock Analysis appeared first on SmartAsset Blog.

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