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You may have heard of bottom-up and top-down investing approaches, but do you understand how these investing approaches or strategies actually work? Otherwise, read on to find out.

From bottom to top

Using a bottom-up investing approach, a portfolio manager will take a close look at the fundamentals of a stock. They will look for companies that they believe will perform well over time, based on factors such as the company’s management team, low price-to-earnings (P / E) ratios and the potential for earnings growth. If the company looks strong, these investors believe it will continue to perform well over time, regardless of how the market as a whole moves. They will pay little attention to market conditions or industry fundamentals and will focus on a company’s performance in one industry over another in order to choose the stock they feel is most likely to be successful. to augment. (See also: What is the difference between “top-down” and “bottom-up” investments?)

Bottom-up investors also believe that just because one company in one industry is doing well doesn’t mean all companies in the industry will continue to perform well. These investors try to find particular companies in one industry that will outperform others. This is why they spend so much time analyzing a business. They can even visit the company’s headquarters and factories and speak with the company’s management team. Bottom-up investors will also read research reports that analysts publish on a company they are considering buying, as analysts often have intimate knowledge of the companies they cover. The general idea behind this approach is that individual stocks in a sector can perform well, regardless of a poor performing sector. (See also: Should you follow the millionaires in this industry?)

Typically, investors looking to invest for a long time will use a bottom-up approach because they invest with the belief that the business is and will continue to be good despite market fluctuations. The stock price may, indeed, go down along with the market as a whole, but these investors expect it to rise again and outperform as the overall market improves.

From top to bottom

In contrast, a top-down investor will look at various economic factors to see how these factors can affect the overall market, and therefore the stocks in which they wish to invest. It will analyze gross domestic product (GDP), falling or increasing interest rates, inflation, and commodity prices to see where the stock market may be heading. They will also look at the overall performance of the sector or industry in which a stock is located. These investors believe that if the industry is doing well, there is a good chance that the stocks they are looking at are doing well and generating returns. These investors can consider how external factors such as rising oil or commodity prices or changes in interest rates will affect some sectors relative to others, and therefore companies in those sectors. (See also: A top-down approach to investing.)

For example, if the price of a commodity such as petroleum increases and the company in which he plans to invest uses large amounts of petroleum to manufacture his product, the investor will assess the effect that the rise in prices. oil prices will have on the company’s profits. Their approach therefore begins very broadly, by looking at the macroeconomics, then the sector and finally the stocks themselves.

Top-down investors can also choose to invest in a country or region, if its economy is doing well. So, for example, if European stocks falter, the investor will stay out of Europe and can instead invest money in Asian stocks if that region is growing rapidly. (See also: Top-down analysis: finding the right stocks and sectors.)

Short-term investors can use a top-down approach, as they seek to profit from market fluctuations, which occur based on forces outside of the company itself. They will enter and exit stocks more often than bottom-up investors. Both investment approaches are valid and should be taken into account when designing a portfolio of companies in which to invest. Just make sure you know why you are buying 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 business to decide whether or not to invest in it. In contrast, top-down investors take general market and economic conditions into account when choosing stocks for their portfolios. (See also: Explanation of bottom-up and top-down investing.)

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