Assessing whether to invest in a particular company can be challenging without considering the various associated factors. Whether parking excess funds in a particular business would yield attractive returns depends not just on the enterprise, but also on the economic conditions of the market as a whole.
In this regard, top down investing or analysis is a better approach. Such investment avenues can help individuals manage their expectations regarding gains by performing a distinct study of all macroeconomic factors.
What is Top-Down Investing?
Top-down analysis approach starts by looking at the bigger picture or the macroeconomic factors in play. Therefore, before deciding on whether an investment is particularly beneficial, investors need to begin by studying the country’s GDP, inflation rates, rise and fall of interest rates.
After this analysis is complete, investors will use this data compiled to predict how a stock market would perform in the upcoming days. Finally, based on this prediction, they will decide whether a particular business’s stock has the potential to earn great returns on investment.
For example, consider that the price of aluminium has appreciated significantly. Under such a situation, individuals looking to invest in a company, which utilises large quantities of aluminium in their products, will need to assess the macroeconomic factors in play. With the top down approach, investors will be able to gauge the extent to which the company’s profits would be affected due to the rising cost of aluminium.
Top down investing contrasts with a bottom-up approach, where the primary emphasis is on a business where one is considering investments.
Order of Analysis in Top Down Investing
The top down approach relies on careful analysis of various economic factors, in the following order.
|Macro||These are factors related to a nation’s economy, such as GDP, inflation and more.|
|Sector||In this second leg of analysis, investors limit their study to just a sector where they want to invest. Thus, an individual looking to invest in a car company would analyse the current market performance of the automobile sector as a whole, determining future opportunities or challenges that the sector faces.|
|Firm||The last step in top down investing is assessing the potential of a particular business or company whose stocks an investor wants to purchase.|
Macroeconomic Factors Relevant to Top Down Investments
As one can understand from the top down analysis example listed above, investors need to take into account several factors besides the potential of a particular company. Listed below are some of the factors that help determine whether an investment is profitable under such an approach.
- Gross Domestic Product – This type of analysis always starts from the highest level – a country GDP. Studying the GDP can help assess the country’s present and future economic growth.
- Political volatility and risks – Before investing in a particular company, investors would also consider the general political atmosphere in its location. Political unrest in a country can lead to immense stock market volatility, thereby exposing investors to the risk of losses. Thus, in top down investing, one looks for geopolitical stability in the region.
- Inflation rate – International investors, must also factor in the performance of the local currency before parking funds into designated stocks. While businesses can seem to be doing well in the local currency, conversion to an investor’s currency may reveal a not-so-impressive growth.
- Valuing the underlying assets – Asset valuation should be considered according to economic growth. While rapid growth in an economy implies that its businesses will also do well, investors must take care not to overvalue the concerned assets.
Only after determining these macro-level characteristics should one proceed with top-down investing.
Salient Benefits of Top Down Investments
After assessing the top-down investment approach, one should consider whether taking this route is beneficial for him/her. It offers the following advantages –
- Such a process ensures that investors know the ideal instrument for maximum gains, regardless of the market scenario and the overall economic condition.
- A top-down investment method also uncovers instances where a large investment would not be appropriate for an investor’s portfolio. Thus, it prevents them from over-investing.
- Considering the macro factors will help investors understand when a market is declining. It will prevent them from investing in stocks even if they fulfil all of the other criteria.
- Top-down investments also encourage diversification. Apart from diversifying one’s investments in the top sectors, such a method also forces an individual to consider top foreign markets.
Investors should also consider the downsides of undertaking a top down analysis.
Drawbacks to Consider
Even though the top-down process seems perfect at first glance, a seasoned investor must consider the following points as well –
- An error in the analysis can prevent investors from leveraging the market conditions to earn substantial gains.
- Top-down investing also presents the issue of under-investing in stock markets, which are on a rise or are expected to rise in the near future.
- The approach also eliminates whole sectors from consideration, without accounting for the top companies under them. Stocks from such companies may be functioning quite well in the market.
- When a market is in near lows, an investor employing this analysis method can miss bargain stocks.
As an investor, one must consider each of these factors before deciding whether top-down investing is suited to him/her. No single approach to investments is without the accompanying advantages and flaws.