Top Down and Bottom Up style of investing is one of the most common terms used in fund management.
Let’s look at an example. Let’s say Tim is a US based businessman wanting to set up a software business. For a software business he would need software engineers.
So, instinctively his mind wanders to India which is known have an abundant supply of software engineers.
Once he has decided that it is India which shall be the source of supply of software engineers, he then decides to contact an HR consultant in India to line up people. He then interviews the engineers one by one and makes his selections.
In this example his decision to select India as the source of software engineers represented the top-down approach while the detailed selection process involving interviews and references etc. represents the bottom-up approach.
A top-down approach is an investment strategy that selects various sectors or industries and tries to achieve a balance in an investment portfolio. The top-down approach analyzes the risk by aggregating the impact of internal operational failures. This approach is simple and not data-intensive. The top-down approach relies mainly on historical data.
A bottom-up approach, on the other hand, is an investment strategy that depends on the selection of individual stocks. It observes the performance and management of companies and not general economic trends. The bottom-up approach analyzes individual risk in the process by using mathematical models and is thus data-intensive. This method does not rely on historical data. It is a forward-looking approach unlike the top-down model, which is backward-looking.
In the event of fund management similarly the fund manager’s decision of investing in emerging markets would represent the Top-Down approach while the detailed selection process of companies based on size, turnover, profitability, management quality etc. would represent the Bottom-Up approach.