Top-down and bottom-up are two approaches to investing. Let’s look at what each of these two approaches means.
Under the top-down approach, an investor looks at the big picture. An investor first chooses which sector is going to do well. Then he moves on to find which companies in the sector are worth investing in. Alternatively, he might look at a particular set of stocks – say old economy stocks. He might move on to picking companies in the old economy which are going to do well.
Under the bottom-up approach, an investor finds which companies are going to do well in the future. He analyses them and buys a few of them.
Let’s take the example of a top-down approach. In March 2020, some investors correctly identified that the steel sector will do well. They then could have moved on to finding which companies suited their circle of competence. explains the idea of the circle of competence. Let’s say you identified SAIL (Steel Authority of India). SAIL has then delivered stupendous returns in the next 1 year.
Let’s say some investors identified that aluminum prices would rise in 2020. He would then find out which companies produce aluminum. He would then zero in on buying some aluminum company that is within his circle of competence. Say he would have zeroed in on Hindalco in April. Hindalco delivered nearly 300% returns in the financial year FY 2020-21.
Now, let’s look at the bottom-up approach. An investor finds that a particular company would deliver good sales growth in the next 3-4 years. He would analyze the company and if he finds that the company is worth investing in based on its future prospects, he would go ahead and buy it.
There are variations in how different people view top-down and bottom-up approaches. Under the top-down approach, some people consider the economy as a factor. So, they look at economic reforms, interest rate scenario, economic growth rate, bond yields, etc. as key factors. So, they first consider the economic situation expected in the future. Then they move on to identifying which sectors are going to do well. After that, they zero in on individual companies. Many global investors first look at which countries are going to do well in terms of economic growth. They might look at which would be the fastest-growing countries in the future. From among these countries, they may zero in on a few countries. After identifying the countries, they move on to the individual sectors and then individual stocks.
Which approach should investors choose – top-down or bottom-up? Whatever approach they choose, they should stick to their circle of competence. Also, some individual investors choose the top-down approach in some cases and a bottom-up approach in other cases. Whatever approach you choose, the end objective is the same – to identify sound companies to invest in. Look at what will happen in the future and invest.
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