In the stock market, investors use a number of different strategies to minimize risk and to maximize their return. One of such strategies used by many investors is a top down approach to investing.
In top down approach, an investor first understands the ups and downs by looking at the macro picture of the economy, and the business and then selects the right company within that industry to invest for the right price at a good time.
The main reason for this approach is that the broader economy is the main factor behind the success of the individual companies. Changes in the economy can have an adverse impact on the company’s financial position.
For instance, in case of a slowdown in the economy, consumers and customers cut down their spending due to which expected revenue and profit can no longer be achieved by the company. Therefore, the value of the company can come down below the market price.
In case of high debt, the company will not be in a position to pay back its dues.
Steps followed in top-down approach to investing
Here are the steps followed in top-down investing approach;
- Deciding the country that suits best for investing. While analysing the country, investors use all macroeconomic variables such as the country’s gross domestic products (GDP) growth, inflation, interest rates, trade balance, war, geopolitical tension and currency movements.
- Analyzing specific industries within that country to know which industry can grow at a higher rate compared to the total market. The objective is to find out those sectors, industries that can outperform the market.
- Selecting individual companies within the selected industry to invest.
In top down investing approach, investors choose many tools and indicators to assess the ground reality before investing. For instance to select individual stocks, investors look at the company’s fundamental and technical aspects.
In fundamental analysis, you analyse a company by looking into the financial statements and then try to go deeper into the company’s business to get an idea of the whole picture. In case of an economic downturn, expected earnings will come down as the company will not be generating much revenue.
Here are few financial tools used in fundamental analysis to determine the company’s valuation;
- Price to earnings ratio – P/E
- Price to book value – P/B
- Growth in sales and earnings
- Price to sales ratio
- Dividend yield
- PEG ratio
- Return on equity – ROE
- Free cash flow
- Debt-to-Equity – D/E
International investors also analyse different risk factors associated to the industry and to the company before investing. According to them, a well established company can’t grow as expected if the industry and country’s situation did not allow it to grow.
Bottom-up approach is an opposite to top-down investing approach.
In a bottom-up approach, investors first start with the company’s fundamentals, and then they move way up to analyze how the industry and country will grow for the invested period. As per these investors, fundamentally strong companies with good management will perform well over time regardless of how the overall market may be doing.
In a top-down investing approach, investors start from the general (looking at the macroeconomic factors first) to the specific (picking individual stocks), whereas in bottom-up, they begin with a specific individual stock or company and move to the general.
Which investing approach you should use: top-down or bottom-up?
To be very honest, there is no right or wrong answer to this question, as there is no single approach to investing in stocks.
It depends on your investing style and investment goals. You need to find out the best approach that best fits your goals and objectives. Many investors combine both investing approaches to build a well diversified portfolio.