The Bottom-Up Approach for Investing

You might have heard investors described as having a "top-down" or "bottom-up" approach. These two terms are used to distinguish the primary focus of a given investor. Some investors take a holistic approach, surveying the health of the market in general before making individual investment decisions, while others look for specific stocks they think will perform well no matter which way the market goes. A good balance of both is usually key to smart investing.

Identification

The term "bottom-up" describes a particular approach to investing. Bottom-up investors are more interested in the analysis of a given company's performance, regardless of trends in the overall market. For example, an investor who chooses a technology stock based on its products, market shares, and cost benefit, rather than the overall trend of the market or current technological advances, is taking a fundamentally bottom-up approach to investing. As noted in "The Theory and Practice of Investment Management," bottom-up investors are also characterized as those who focus on technical analysis of particular stocks.

Contrast With Top-Down Approach

Unlike bottom-up investors, top-down investors investigate sectors and market trends before they start analyzing particular stocks. Their investment decisions are guided by the current and projected state of the market, rather than the numbers of a particular stock. Some top-down investors may pass on stock investment altogether if the market doesn't look favorable in the near future. You could say that top-down investors are "big picture" people, whereas bottom-up investors are more detail oriented in their decision making.

Advantages

Bottom-up investment approaches have a variety of advantages for active investors, according to My Stock Market Power. For experienced investors who have a good sense of short-term market performance, and know what to look for in a given stock, a bottom-up approach may have high gains, particularly during periods of decline, or bear markets. Top-down approaches aren't always foolproof, since market conditions can change unpredictably, and competing investors can also attempt to decipher trends and use them to their own advantage. Additionally, a decline in a particular sector doesn't always have negative consequences for strong stocks in that sector.

Disadvantages

The top-down approach does have a few advantages over bottom-up investing. For less experienced investors, top-down investing provides a way to narrow down the most profitable sectors. Additionally, with thousands of stocks to choose from, investors may not have time to sort through every single stock, regardless of sector, and analyze their numbers. For the everyday investor, a balanced combination of the top-down and bottom-up approaches helps limit stocks by sector while also analyzing particular stocks in that sector to maximize returns.