“Top Down” Investment Approach

by ABC

Victoria Falls

If you read the business pages or investment in mutual funds you will often hear portfolio managers described as “bottoms up investors” or “top down” in their investment approach.  Here is an explanation of “top down”.

The investor using a top down investment approach looks at the big picture. Macro economic variables such as the global economy and individual country statistics such as national GDP, trade balances, currency movements, inflation, interest rates, commodity price trends are used to determine where to invest and in what types of assets.

Although there is no statistical measure of political stability, it is just as important a factor in determining the risks involved in a country. Market sentiment is also another variable. Once these assessments are completed, asset allocations are then made in the country, group of countries, sector or currency.

The idea in a top down approach is to weigh broad macro variables and then shift investments accordingly i.e. to make money by shifting assets rather than by analyzing companies. Picking individual securities is usually the last step in this strategy.

For example, if economic and growth in China and Asia are deemed stronger than the USA, then an international investor will allocate more money to Asian counties by buying a handful of blue chips, country index funds or exchange traded funds or sector specific funds.

Alternatively in a top down sector analysis, if oil prices are expected to drop because of oversupply and declining demand, then you might consider buying airline stocks as they usually benefit from lower fuel costs.

The top down approach can also be used to make money from expected changes in interest rates and exchange rates of two countries. For example, if the Deutschmark is deemed undervalued relative to the US dollar, then it would make sense to overweight German securities and to make gains from a likely appreciation of the currency in addition to stock gains.

A top down strategy places importance on economic, market and industry cycles as they come in and out of favor. A downside is that a top down investor may lose out on spectacular gains from a rigorously researched stellar stock.

Photo Credit: Zest-pk

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