A Detailed Look at Top-Down Investing

Top down investing is a method of analyzing the market as a whole when picking securities. Instead of concentrating on detailed analytics, top down investors look at overall market conditions, market sentiment and large-scale statements of financial health before picking sectors in which to invest. Top down investing results in mixed success. Some investors and analysts believe it is superior to bottom up investing, but others believe it falls short of truly detailed analysis of securities.

Theory behind Top Down Investing

The theory behind top down investing is simple: no securities exist in a bubble. They are all subject to the overall market trends, successes and failures. Each single financial indicator on a security results from a variety of other indicators. For example, return on equity (ROE) ratios can depend on the sector of business operation, the season and the type of equity held by the company. Since every factor is interconnected with several others, top down investors see it as prudent to consider the whole picture instead of individual factors. They look for predominant trends rather than suspecting they can forecast gains based on a narrow view of analysis.

Factors Used in Top Down Investing

Some factors top down investors consider include political, geographic and even the physical climate. For example, an oil speculator will take into account the current pressures being placed on the Organization of Petroleum Exporting Countries (OPEC) when trading options and commodities contracts. This speculator will consider the political climate that may cause a change in production. Applying the top down approach, the investor will also think about the general use of oil worldwide, taking into account movements toward electric vehicles in developed nations and the spread of gasoline-powered automobiles to developing countries. With these factors in mind, the speculator may decide oil prices will continue to rise for the next few months.

Alternative: Bottom Up Investing

A bottom up investor would view the above scenario from an entirely different angle altogether. This investor would start by looking at oil prices themselves, perhaps using a model of the commodities price for the past fourteen days to estimate whether it will rise or drop in the next fourteen. This investor is more likely to use actual formulae rather than an overall interpretation to make guesses about whether the time is ripe to invest or whether the time is ripe to sell short.

Which Is Best?

The easy answer to the question of which approach is best is "neither." While factors such as ROE, volatility, cash flow and other indicators provide accurate analyses in a narrow window, they fail to show the full picture. By selecting only a handful of features by which to analyze a security, an investor may make the wrong decision just because he or she ignored other factors. By contrast, a top down investor who fails to consider a detail like a company's ability to pay its debt, known as interest coverage, may wrongly invest in a company that is bound for bankruptcy. The best answer, then, is to consider both the overall market climate as well as significant individual features. 

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