Top Down/Bottom Up: Two primary investment approaches, with one (top down) emphasizing economic and sector analysis before company specifics and the other (bottom up) emphasizing company specifics only.

Visually speaking, top down/bottom up seems alternately related to drinking and driving. (As in "the top is down; now bottoms up!") But if you have clients in the investment industry, be they analysts, brokers, fund managers or what have you, or even if you just own shares in a mutual fund or two, you've heard of or read about a top down or bottom up approach to investing, which is so far from self-explanatory that you may have, like Pocket MBA, just glossed it over as so much gobbledygook (which is actually in the dictionary: "wordy and generally unintelligible jargon").

Top Down/Bottom Up: Two primary investment approaches, with one (top down) emphasizing economic and sector analysis before company specifics and the other (bottom up) emphasizing company specifics only.

Visually speaking, top down/bottom up seems alternately related to drinking and driving. (As in "the top is down; now bottoms up!") But if you have clients in the investment industry, be they analysts, brokers, fund managers or what have you, or even if you just own shares in a mutual fund or two, you've heard of or read about a top down or bottom up approach to investing, which is so far from self-explanatory that you may have, like Pocket MBA, just glossed it over as so much gobbledygook (which is actually in the dictionary: "wordy and generally unintelligible jargon"). And as the primary goal of Pocket MBA is to ensure we know what people are talking about, we need to eradicate that scatology or drinking and driving imagery from our heads. So let's be quick and to the point.

Almost exactly three years ago (Volume 2, No. 41 to be precise), Pocket MBA delved into "technical analysis," which is a market-activity based method for investing (or trading). Technical analysis is the ultimate "trend is your friend" method, even though it is quite complex in its variations. Top down or bottom up approaches are fundamentals based—that is, analysts (primarily fund managers) who use one or the other (and sometimes both) look to how companies, the economy or both are doing to determine what investments to buy.

Top down is a macroeconomic approach to investing, with its practitioners concerned first and foremost with the conditions of the economy as a whole and, secondarily, with individual sectors in the economy. Only after assessing the macro state of the economy will a top-down investor get to the qualities of specific companies. In today's economic climate, a top-downer would focus on the health of developed economies and on the explosive growth in the emerging market economies. (This includes geo-political considerations; it's tough to profit off political instability.) Top downers will look at trends in employment, interest rates, currency strength and the like to ensure that the investment climate is positive.

Having determined that there is economic strength justifying an equity investment (and if there isn't, the top downer might just park his money in some conservative interest- or dividend-bearing instrument), the top downer might focus on the particular countries that benefit from the current growth trends in the emerging markets, like China and India, but also on the United States (which benefits via exporting resulting from a weak dollar).

The top downer will also try to determine the sectors that are driving that growth—infrastructure, commodities (such as energy, metals, wheat and timber), international banking, etc. A money manager might conclude from all this that certain sectors in certain economies present fertile ground for investment growth. In the current environment, a top downer could decide that the growth in China is so stupendous that any company that is doing business in or profits from the growth of that country is worth looking into. It is at this point that the top-down investor will focus on individual companies to determine which make the strongest investments. And those decisions are based on the fundamentals of each company. This latter step is the closest a top downer comes to bottom-up investing. Having made the determination about what sectors to invest assets, the top downer still has to determine which companies are best.

Bottom-up investing is easier to understand, is diametrically opposed to top down investing and is used by more fund managers than not. The bottom-up investor focuses on the qualities of individual companies first and last. That is, you start where the top-down investor finishes. The bottom-up investor will theoretically look into the strength and prospects of any company in any sector in any country. The macroeconomic issues are of little concern because a good company is a good company is a good company. If a particular company presents a good value proposition (and the bottom-up investor will try to determine which company is the best value proposition), its stock can be bought in good economic times or bad.

Warren Buffett is a notorious bottom-up investor. Pocket MBA doesn't know any famous top-down investors, though there must be some. Specialty mutual funds (like sector funds and country funds) are prime examples of the top down approach, though one could argue that having pre-determined what area the fund is placing its money, the individual selections are bottom up. And all this makes Pocket MBA want to belly up, so bottoms up.