The top-down investing approach is one of the most common types of investment research strategies. But what are the advantages and disadvantages of this investment approach?
In this article, we will go over the main advantages and disadvantages of using a top-down investment approach.
What is a top-down investing approach?
A top-down investment approach involves looking at the macro picture to identify investment opportunities. This involves researching and analyzing macroeconomic indicators, to determine which industries and sectors are the most attractive.
After identifying these sectors, analysts will then research and analyze stocks. The top-down approach allows investors to reduce the number of stocks they might be interested in, to only analyze the ones that are expected to achieve the best returns.
What economical indicators do investors use to conduct a top-down investing approach?
Depending on the type of fund, and investment conducted investors and fund managers might look at different indicators to select the best industries. However, here are some of the main indicators they analyze:
- GDP growth across different countries
- Industry growth
- Interest rates
- House prices
- Inflation (CPI)
- Analyze financial markets
GDP growth across different countries
Investors with global exposure will often analyze GDP across different regions of the globe. Not only to identify countries that are growing at a fast pace, but also to identify the laggers.
This allows them to understand exactly what are the most attractive regions, even if they are not looking to invest directly there. For example, China is set to continue growing rapidly, but to mitigate the risk of investing there, investors might look for stocks to have indirect exposure to the explosive growth of the country.
Looking at some of the countries that are struggling to grow their GDP, or it is even declining also allows them to profit and short the country.
Unemployment is also one of the most important macro indicators that investors can use to determine the growth of the economy. Analyzing unemployment with the disposable income of families, allows investors to make predictions on retail sales, and even how the housing market will perform.
Another important indicator is how a specific industry is set to grow over the long term. The top-down investing approach allows investors to narrow down their investable universe to the most attractive industries.
Interest rates determine the cost of capital, and naturally have a great influence on the economy and how some companies perform. While low-interest rates can boost high-growth companies like SaaS, a high cost of capital could spell trouble for high-growth industries that need cheap capital.
Top-down investors are well aware of how interest rates can dictate the valuations of stocks and their influence on stock market prices.
The housing market also has a great influence on how investments will perform. Houses remain one of the main investments that families make. If house prices are going down, that means that most of the retail investors’ net worth is declining, which can make it difficult for the stock market to go up.
Inflation is also an important macroeconomic indicator that you need to consider for top-down investment analysis. Looking at the consumer price index (CPI), and producers price index (PPI) will be some of the most important data points to assess the current inflation and its outlook.
Analyze financial markets
Finally, to conduct a proper top-down approach it is also important to analyze financial markets. Not only the stock market and its current valuation but also commodity markets and currency markets.
What are the advantages of a top-down investment approach?
There are several advantages to using a top-down approach, such as:
- It saves time
- It is a broader approach to investing
- It makes you a better investor by expanding your circle of competence
- Easier to manage macro risks
- Improves your ability to allocate capital
- It can allow you to time the market
It saves time
One of the greatest advantages of the top-down approach is that it can save you a lot of time. Instead of having to look through thousands of individual securities, you can easily narrow down your investable universe to the most attractive industries, sectors, and even geographically.
Since you narrow down each of the most attractive subsets of the investment opportunities available you can then research them one by one.
It is a broader approach to investing
A top-down approach can push an investor to take a more global approach to looking for investments. This can be a great advantage because it can push you to research opportunities you would not find anywhere else.
It makes you a better investor by expanding your circle of competence
This type of investment approach can also push you to become a better investor. Since you are forced to look at the bigger picture, you might find yourself analyzing and researching investments outside of your circle of competence. It forces you to broader your edge of competency, which is a great way to develop your investing abilities and skills while becoming a better investor.
Easier to manage macro risks
Another advantage of the top-down investing approach is that it gives you a better understanding of macroeconomics. This allows you to foresee risks, and hedge your portfolio accordingly. While bottom-up investors might be too focused on how a particular stock is performing, and might not be aware of the overall macro outlook.
Improves your ability to allocate capital
Since you expand your edge of competency, you become a better capital allocator. You will need to look at different asset classes, and while being able to understand how each asset class should perform based on macroeconomic conditions.
It can allow you to time the market
Studying and keeping track of macroeconomic indicators is perhaps the best way to understand how the business cycle works, and it may allow you to know when a bear market or bull market is coming. If you want to have an active portfolio management approach, where you try to time the market, the top-down approach will be essential.
However, there are clear risks when you try to time the market.
What are the disadvantages of the top-down investment approach?
Here are the main disadvantages of the top-down approach:
- It is based on predictions and projections
- You need to understand economic, and macroeconomics
- Macroeconomic indicators are constantly changing
- You may miss interesting opportunities
- It may push you out of your circle of competence
It is based on predictions and projections
The top-down approach is solely based on analyzing macroeconomic indicators and trying to predict how the market will act. Predictions are not always right, and it is impossible to always predict the stock market accurately. Therefore, one of the risks associated with the top-down approach is the uncertainty of how the macroeconomic environment will behave.
You need to understand economic, and macroeconomics
While the bottom-up investing approach requires a deep understanding of accounting and finance, the top-down relies on economics and especially macroeconomic knowledge. If you are not knowledgeable in economics you will have a hard time understanding exactly how macroeconomics can influence everyday life and businesses.
Additionally, every economic indicator can be interpreted differently by different economists, financial analysts, and even fund managers. This is one of the reasons why macroeconomics can be such a complex topic.
Macroeconomic indicators are constantly changing
Another thing to keep in mind is that macroeconomic indicators are constantly changing, so you will need to keep up with this constant change. Although top-down investing may save you some time identifying attractive industries, it is challenging to keep up with changing macroeconomic data and understand exactly how it will affect your investments.
You may miss interesting opportunities
The top-down approach may also make you miss some interesting opportunities. For example, if you are discarding sectors, and geographies upfront just because their outlook is not promising based on macro indicators, that does not mean that there aren’t interesting companies in those regions or sectors.
It may push you out of your circle of competence
While becoming a better investor is important, it is also crucial to stay within your circle of competence. You want to avoid investing in industries or regions that you do not know so well. Staying within your circle of competence only improves the success rate of each investment you make.
Why do investors use a top-down investing approach?
Investors use the top-down investing approach because it allows them to pick the most interesting industries in which to research stocks. Instead of analyzing multiple individual stocks, this allows them to narrow down the most attractive industries.
This type of investment approach also allows you to save time, and it is a lot less time-consuming than researching individual stocks. There are only so many stocks you can really analyze thoroughly and value accurately.
For that reason top-down investors often tend to invest in ETFs, making it easy to select specific industries, and regions that look attractive and are expected to grow.
While using a top-down approach has several advantages, there are also a lot of drawbacks. Investors should obviously be aware of the macroeconomic picture, and try to pick the most interesting industries and regions to invest in.
As an investor, it is important to be aware of both a top-down and bottom-up approach, and use them both. This is the only way to become a better investor and to make sure you are making the best decisions.