Many new investors entering into stock markets have a common question – What approach should I have? Should I start with a ‘big picture’ i.e. economy, GDP growth rates, interest rates, currency rate, commodity prices, inflation etc which can affect broader stock markets which eventually will affect the price of an individual stock or should I start directly with a company without much concerns about the overall economy?
The first approach of investing is called as “Top Down Approach” while the latter is “Bottom Up Approach”.
Top Down Approach – Top down approach starts with analysing macro level events like global economy, GDP rates, currency and commodity prices like gold & crude oil, interest rates, inflation. After analysing these macro factors different sectors and industries are selected which are most likely to be benefited due to current and forecasted future macro-economic conditions. After shortlisting the sectors and industries, stocks are shortlisted which can be most benefited in current and forecasted future scenario.
E.g. in falling interest rate scenarios highly leveraged industries like transportation, power, steel, infrastructure are benefitted.
Here are some pros and cons of Top-Down Investing
• Time saver: As you start with a broader look, you can reuse the broader information to make other investments.
• Risk Control: Top-Down approach is generally adopted by long term and risk averse investors and generally avoids volatile, sensitive stocks
• Without Bias: In bottom up approach starts directly with investing in individual stocks. Most of the times these investments are made on rumours or the companies which are popular or make popular products.
• Complex and Time Consuming: As Top Down approach needs detailed study of broader terms, extensive and detailed study is necessary before making investments. Generally, retail investors find it difficult due to lack of expertise and resources.
• Sector can be right, company may not: Even if you choose right sector, the company which you invest in may or may not perform well. Hence even after detailed research and choosing right sectors, you may end up losing your investments.
• Doesn’t work in bear markets: The top-down approach only works in bull markets and investors generally don’t adopt the approach in bear markets. (Bull is rising markets and bear is falling markets)
Bottom Up Approach- Bottom up approach starts with identifying the companies which have good management, good product line, high growth potential and cheaper valuations compared to its peers. In this approach, it is believed that even if economy and industry performs well, the company may not outperform, if the management is not competent or it has no significant product line.
E.g. In a stagnant economy Eicher Motors could outperform due to hit product line of Royal Enfield. (doesn’t necessarily mean that the companies with popular products will outperform like mentioned earlier)
Here are some pros and cons of Bottom Up Investing
• Less complex and time consuming: As the process doesn’t need extensive study and research, the process is easy for retail investors.
• Good for seasoned investors: Investors with good sense of short term investment opportunities who generally know how to invest for a short term adopt bottom up approach.
• Not good for new or unexperienced investors: Investors with little experience find it difficult to shortlist a company to invest in for a short term perspective.
• More risk: Bottom up approach is exposed to more risk as no extensive study is done to make investments.
To conclude both approaches are required to maximize the profits. Top down approach can be used to shortlist the sectors which can boom in the future while bottom up approach can be used to short list the stocks from the shortlisted sectors. The ultimate goal as an investor should be maximizing the profits with minimum risk and not debating which approach is better.
Chinmay Madgulkar is an Electronics & Telecommunication engineer from University of Pune. He has completed his MBA in Finance from Xavier Institute of Management & Research and is a Management Trainee - Equity at Taurus Mutual Fund. He is also a Mutual Fund advisor. You can read all other posts by Chinmay on InsideIIM.com here.
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