You may have heard of bottom-up and top-down investing approaches, but do you understand how these approaches or investing strategies really work? If not, read on to find out. 

Bottom Up

Using a bottom-up investing approach, a money manager will closely examine the fundamentals of a stock. They will look for companies that they believe will perform well over time, based on such determinants as the company’s management team, low price to earnings (P/E) ratios and earnings growth potential. If the company seems to be a strong one, these investors believe that it will continue to perform well over time, regardless of how the overall market may be doing. They will pay little attention to market conditions or industry fundamentals and focus on how one company in a sector is performing compared to another one in order to choose the stock they believe is more likely to rise in price. (See also: What's the Difference Between 'Top-Down' and 'Bottom-Up' Investing?)

Bottom-up investors also believe that just because one company in a sector is doing well, that does not mean that all companies in the sector will also go on to perform well. These investors try to find the particular companies in a sector that will outperform the others. That’s why they spend so much time analyzing a company. They may even visit the company’s headquarters and factories and talk with the company’s management team. Bottom-up investors will also read research reports that analysts put out on a company that they are considering buying, as analysts often have an intimate knowledge of the companies they cover. The overall idea behind this approach is that individual stocks in a sector may perform well, regardless of a poor performing sector. (See also: Should You Follow Millionaires Into This Sector?)

Typically, investors looking to invest over a long period of time will use a bottom-up approach as they are investing based on their belief that the company is a good one, and will continue to be, despite market swings. The stock may, indeed, go down in price, along with the overall market, but these investors expect that it will rise again, and outperform, as the overall market improves.

Top Down

By contrast a top-down investor will examine various economic factors to see how these factors may affect the overall market, and therefore the stock they are interested in investing in. They will analyze gross domestic product (GDP), the lowering or raising of interest rates, inflation and the price of commodities to see where the stock market may be headed. They will also look at the performance of the overall sector or industry that a stock is in. These investors believe that if the sector is doing well, chances are, the stocks they are examining will also do well and bring in returns. These investors may look at how outside factors such as rising oil or commodity prices or changes in interest rates will affect certain sectors over others, and therefore the companies in these sectors. (See also: A Top-Down Approach to Investing.)

For example, if the price of a commodity such as oil goes up and the company they are considering investing in, uses large quantities of oil to make their product, the investor will consider how strong an effect the rise in oil prices will have on the company’s profits. So their approach starts out very broad, looking at the macroeconomy, then at the sector and then at the stocks themselves.

Top-down investors might also choose to invest in one country or region, if its economy is doing well So, for instance, if European stocks are faltering, the investor will stay out of Europe, and may instead pour money into Asian stocks if that region is showing fast growth. (See also: Top-Down Analysis: Finding the Right Stocks and Sectors.)

Shorter-term investors may use a top-down approach, as they are looking to profit off of swings in the market, which occur based on forces outside of the company itself. They will get in and out of stocks more often than bottom-up investors will. Both approaches to investing are valid and should be considered when designing a portfolio of companies to invest in. Just make sure you know why you are purchasing the stocks you are buying, consider the necessary factors and be aware of market trends.

The Bottom Line

Bottom-up investors will research the fundamentals of a company to decide whether or not to invest in it. By contrast, top-down investors take into consideration the broader market and economic conditions when choosing stocks for their portfolio. (See also: Bottom-Up and Top-Down Investing Explained.)