Top-Down versus Bottom-Up: An Overview
Top-down and bottom-up approaches are methods used to analyze and choose securities. However, the terms appear in many areas of business, finance, investing, and economics. While the two rhetorics can be common terms, many investors get them confused or don’t understand the different approaches at all.
Generally, each can be quite simple. The top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general.
Comprehensively these generalizations may be possible approaches for a wide range of endeavors such as budgeting, goal setting, and forecasting. However, in the financial world, analysts or whole regimes may be tasked with focusing on one over the other so understanding the nuances of both is important.
Top-down generally refers to using holistic factors as a basis for decision making. The top-down approach will seek to identify the big picture and all of its components. These components will usually be the driving force for the end goal.
Overall, top-down is commonly associated with the word macro or macroeconomics. An analyst seeking a top-down perspective will want to look at how systematic factors are affecting an outcome. In corporate finance, this can mean understanding how big picture trends are affecting the entire industry. With the tasks of budgeting, goal setting, and forecasting the same concept applies-understanding and managing the macro factors.
In the investing world, top-down investors or investment strategies focus on the macroeconomic environment and cycle. These types of investors usually want to balance discretionary investing against staples depending on the current economy. Comprehensively, when an economy is expanding, discretionary overweight can be relied on to produce returns. Alternatively, when an economy is contracting or in a recession, top-down investors will usually overweight to safe havens and staples.
Investment management firms and investment managers can focus an entire investment strategy on top-down management that identifies investment trading opportunities purely based on top-down macroeconomic variables. These funds can have a global or domestic focus which also increases the complexity of the scope. Typically, these funds will be called macro funds.
Top-down investing strategies typically focus on exploiting opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
Bottom-up takes a completely different approach. Generally, the bottom-up approach will be more focused in its analysis of specific characteristics and attributes that are important.
In the investing world, bottom-up investing is usually heavily focused on fundamentals. Bottom-up investing is often more segregated with a specific focus on an industry sector or market. This means that regardless of the macroeconomic variables, bottom-up investors seek to identify profitable opportunities through the idiosyncrasies of a company’s attributes.
As such, bottom-up investing can be somewhat broad across an entire industry or laser-focused on identifying key attributes. For example, a portfolio team may be tasked with a bottom-up investing approach within a specified sector like technology. Regardless of the macro environment, they are required to find the best investments using a fundamental approach that identifies the companies with the comprehensive ratios or industry leading attributes. Metric focused smart beta index funds are another example of bottom-up investing.
Funds like the AAM S&P 500 High Dividend Value ETF (SPDV) and the Schwab Fundamental U.S. Large Company Index ETF (FNDX) focus on specific fundamental bottom-up attributes that are expected to be key performance drivers.
Generally while top down and bottom up can be very distinctly different they are often used in all types of financial approaches as checks and balances. For example, while a top-down investment fund might primarily focus on investing according to macro trends, it will still look at the fundamentals of its investments before making an investing decision. Vice versa, while a bottom-up approach focuses on the fundamentals of investments, investors still want to consider systematic effects on individual holdings before making a decision.
- Top-down usually encompasses a vast universe of macro variables while bottom-up is more narrowly focused.
- Top-down investing strategies typically focus on exploiting opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
- While top down and bottom up can be very distinctly different they are often each used in all types of financial approaches as checks and balances.