Investing in the stock market is a daunting task, and with no shortage of products or investment options available. An overload of options can leave investors bewildered as to how to proceed. Have you ever flipped through a restaurant menu and struggled to order from a list of enticing items? A similar type of indecision can occur with investing, leading to investment inertia and risk aversion, which may ultimately have a negative impact on meeting your long-term financial goals. There are many strategies out there, but there are two common approaches that can help organize your analysis: top-down investing and bottom-up investing. Below we will explore the key differences between the two methods.
Top-down investing is a strategy that involves reviewing and forecasting market and economic trends to make investment decisions. This approach involves analyzing a myriad of macroeconomic factors, such as GDP, labour market, interest rates, inflation, and even geo-political events, to identify countries and sectors that have the potential to perform well. Investors who use this approach focus on the bigger picture and make investment decisions based on these macro trends. Generally speaking, this approach may come naturally or more intuitively for investors who already keep up to date with the ‘business’ sections of the news. After performing the necessary top-down analysis, an investor could utilize broad-based mutual funds or ETFs to create the targeted asset allocation and sector exposure. Investors could also drill one step further and search for promising stocks within the sector that they suspect will outperform.
Bottom-up investing involves analyzing individual companies and their financial statements to make investment decisions. The nature of this approach is more granular and may require extensive due diligence and time. Here, investors make an effort to look at the company fundamentals, such as earnings, cash flows, revenue growth, debt levels, and quality of management, among others, to identify attractive companies with positive trends and growth potential. The attractiveness of these fundamentals can be attained by comparing one set of data to other stocks within the same sector or even to the company’s own historical metrics. A limitation of bottom-up analysis is that macro and global economic factors that may have an impact on a company’s performance are not considered. This approach is solely aimed at identifying companies that could outperform the market based on their individual fundamentals. This may prove to be tricky as stock picking is difficult even for the most seasoned investors.
It’s important to remember that these two approaches are not mutually exclusive. Investors can choose to use a combination of the two when making investment decisions. However, these methods require building sufficient expertise and these approaches alone may not even be adequate to build a customized portfolio. Afterall, there are additional considerations such as taxes, estate planning, and cash flow needs which will also influence the type of investments and risks one could take. This is where your investment advisor can help. Investment advisors can help you develop long-term investment and savings strategies by helping you understand your financial goals and ability to take risk. If you find yourself overwhelmed and unable to confidently self-manage your wealth, work with your investment advisor to help achieve your financial goals.