Skip to main content

Investment Approach : Top down and Bottom up Methods



Traditionally, there exist two strategies for investing in stock markets. One is the 'top-down approach', where the investor analyses the overall macroeconomic scenario, picks sectors that will do well in the given macro scenario and then selects stocks from those sectors that are cheap. This approach presumes that macro factors influence the sector and stock performances more.


The second approach is the 'bottom-up approach, where the investor directly considers a universe of stocks based on independent analysis and parameters. Within the universe, he or she identifies stocks with good potential irrespective of the sector to which the stock belongs, without giving much weightage to the overall macroeconomic scenario. This approach presumes that stock specific factors carry more weight than the macro ones. The top-down approach usually requires knowledge and understanding of the economy in general and also about the specific sectors and stocks within it. In the bottom-up approach, the emphasis is on in-depth analysis of the specific stock that is to be purchased or sold. The sectors where the price performance is linked positively to the economic cycles are known as cyclical sectors (high beta). Metals, automobiles, and real estate, etc, fall under this category. Sectors that are little less influenced by economic cycles are known as defensive sectors (low beta). Pharma, utilities, and consumer staples, for example. Such defensive sectors and stocks have steadier earnings and more predictable cash flows.


The top-down approach assumes that by allocating money across different sectors (cyclical and defensive), the investor will be able to diversify his portfolio risk. Even if a sector is extremely attractive, the investor won't be able to invest all his money in it. Many professional money managers using top down approach usually have sector limits, too. Similarly, in the bottom-up approach, too, there will usually be a limit on the exposure to a single stock. But which strategy works all the time? The key to the top down approach is that sector returns should be negatively co-related to each other. A 100% co-relation is perfect comovement with each other and -100% is perfect co-movement with each other but in the opposite direction. The cyclical ones should usually offset some of the weakness in the defensive ones and vice-versa. But as of now, many of the cyclical sectors and the defensive ones have higher and positive co-relations of more than 90% with each other. This breaks down the theory of price movements of cyclical and defensive sectors being self-balancing at least to a reasonable extent. For instance, the traditional defensive sector such as pharma, has a co-relation of more than 80% positive with major sectors, including cyclical ones such as automobiles (98%) or metals (94%).


In fact, the major sector co-relations now are reasonably higher and positive with each other, with many of them above 90%. This does increase the systemic risk in the markets, especially in the event of a steep fall, as all the sectors are vulnerable to the same source of risk or to the same set of factors or to the same type of trades being unwound. The power/utilities sector, a defensive one, has relatively lower positive correlation with other sectors. Surprisingly, only the real estate sector, which typically falls in the cyclical category, has maximum negative co-relation with other sectors such as auto, pharma, and FMCG.


This high positive co-relation between sectors may sometimes defeat the objective of the top-down approach, as defensives act more like cyclical ones. Typically, in the early stages of an economic recovery, especially after a crisis, most of the sectors and stocks exhibit higher positive co-relations with each other as macro-factors dominate more than stock-specific ones. This is in tandem with the margins recovery in general driven by operational leverage, though revenues remain sluggish. As the market recovery matures, sector co-relations should move lower as stock-specific factors start exerting higher influence on prices. The incremental margins typically peak in the later stages of an economic recovery as revenue growth drives earnings.


In other words, when sectors' or stocks' co-relations are higher and are expected to move down, it's appropriate to adopt a bottom-up or a stock picking strategy. And when the co-relations are lower and are expected to move higher, it's time to adopt a top-down or macro strategy. Thus, an appropriate mix of top-down and bottom-up strategies is advisable, depending on the prevailing scenario.

 

Popular posts from this blog

NPS Investment Choice for Safe Investors

Invest NPS Online       Whether they invested through SIPs or put in a lump sum amount, risk-averse individ uals have earned the highest returns. These are investors who stayed away from stocks and divided their NPS corpus between G class gilt funds and C class corporate debt funds. On average, gilt funds have given 9.75% annualised returns while corporate debt funds have churned out more than 11% in the past five years. As a result, the average return for ultra-safe investors in the past five years is in double digits. Even in the short term, ultrasafe investors have been the biggest gainers among NPS investors. Will the good times continue? The gilt funds of NPS are holding long-term bonds with an average maturity of over 19 years and a modified duration of about 9 years.These funds have done well because interest rate cuts have pushed down bond yields. But experts say this trend will not stay forever. NPS is a long-term investment and the bonds are predominantly held to matu...

Buy Health Insurance Plan even if you are covered with my Employer

Buy Health Insurance Plan Online Yes, getting a private insurance cover now, which extends beyond your retirement age, is recommended There are a few reasons why buying a health insurance plan may make sense even though you get medical insurance from your employer. Here are the points you need to think about. Firstly, your employer's insurance coverage will only protect you as long as you are employed with the company. The policy will terminate when you quit the job or when you retire. Post retirement is perhaps the phase when one needs it the most but you won't have it then. Moreover, buying a new insurance policy after the age of 50 means that there will be no coverage for pre-existing diseases.   Lastly, health insurance policy you get from your employer may or may not cover your dependants. ------------------------------ ----------------- Invest Rs 1,50,000 and Save Tax under Section 80C. Get Great Returns by Investing in Best Performing ELSS Mutual Funds Top 10 Tax Saver M...

Surrender ULPPs

  ICICI Pru LifeTime and ICICI Pru Lifestage are Unit Linked Pension Plans. Such insurance linked retirement plans are neither good investments nor do they offer sufficient insurance cover. As you can see, these have turned out to be bad deals. In the Lifetime plan, the fund value is not even equal to the total premiums that you have paid and in the Lifestage plan your return is just about 6% which is quite low. The mortality charges are as per your age which is why they have increased. Moreover, once these plans matures, you will have to compulsorily opt for annuity (regular income) and the annuity rates are generally modest. Assuming these plans mature in the next one year, it will be wise to surrender the plan now and curb your future commitments.   Before you choose to buy a term plan, you have to consider a few points. You need to insure yourself, only during the time you are working and your family is financially dependent on you. At the age of 59, not all insurance companies w...

Mutual Fund Review: Taurus Tax Shield

    Taurus Tax Shield has seen a turnaround in performance since 2007, but still remains a volatile offering… The fund has seen a turnaround in its performance since 2007 and has delivered impressively during market rallies since then. The portfolio is also more diversified. It contained its downfall to an average level in 2008 but is still one of the most volatile offerings in this category. Bold investors can look at this fund.   Strategy The fund manager invests across the market capitalisation and sectors. The selection of stocks is made on the basis of long-term business prospects and value creation. Fund Insight Launched in March 1996, the fund was a laggard with just two annual outperformances. Concentrated stock bets and high exposure to mid and small caps led to it being hit harder during market downturns. The number of stocks in the portfolio never exceeded 20 and it was not rare to see the top 5 holdings account for around 60 per cent of the portfolio. After b...

AXIS Long Term Equity Fund - The Best Tax Saver Fund for 2016

  AXIS Long Term Equity Fund - Invest Online   History:   The open ended mutual fund was launched on December 21 in the year 2009. It is benchmarked against BSE 200 and managed by the fund manager JINESH GOPANI. Initially the scheme was called as Axis tax saver fund but later it was renamed as Axis long term equity fund with effect from September 2, 2011. Nature of investment: As far as asset allocation is concerned, 97.52% of the stocks are equity and 0.02% is debt based. The primary focus of the fund is to invest in diversified equity stocks that have higher growth potential. Total asset size of the fund is in the tune of 4,996 CRORE as of June 30, 2015. Performance: The performance of the fund for one year, 3 years and 5 years are 23.6%, 29.9% and 19.1 respectively which are far greater than 6.4%, 14% and 5.6% benchmark figures. It has also preformed fairly well against SBI magnum Tax Gain (G) and HDFC tax saver (G). The growth comparison is enumerated below;                        ...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now