What Is Top-Down Stock Analysis?
The top-down stock analysis involves starting with a general overview of the economy and then drilling down into individual companies to determine whether particular stocks are currently attractive investments. This approach is based on the assumption that no one stock will outperform the market consistently, and that successful investing requires identifying what sectors, industries, or even types of companies will do well in advance. A top-down investor might, for example, start by looking at the overall health of the economy and then identify industries that are expected to do well in the coming years. From there, the investor would look for specific companies within those industries that are likely to have strong earnings growth and attractive valuations. This approach can be a valuable tool for investors who want to build a diversified portfolio that includes a variety of different types of stocks.
Why Use Top-Down Stock Analysis?
There are several reasons why top-down stock analysis can be a valuable tool for investors. First, it can help investors to identify attractive sectors and industries that may be undervalued by the market. Second, it can help to simplify the investment process by narrowing down the number of potential investments to those that are most likely to succeed. Third, top-down analysis can help investors to build a balanced portfolio by identifying different types of investments. Many investors, for example, like to include stocks that pay out dividends as well as stocks that are seen as growth opportunities. Some may also want to include other assets, such as real estate or bonds. Finally, it can serve an important role in conducting investment research before making a decision to invest.
Overview of the Key Steps
There are four basic steps in the top-down approach to stock analysis:
- Assessing the overall economy and identifying which sectors or industries are expected to do well.
Typically, the top-down analysis starts with an assessment of the economic climate and then drills down into individual companies that operate within that climate. This is because stock performance tends to follow macroeconomic trends such as interest rates, inflation, and gross domestic product (GDP).
- Determining which stocks are attractive within those sectors or industries.
Once the broad overview has been completed, individual stocks can be analyzed to determine whether they are worth investing in. This step typically involves looking at things like the company’s financial stability, competitive landscape, and expected growth potential.
- Weigh the risks and rewards of each investment.
Even within attractive sectors or industries, not all stocks will be equally good investments. Investors need to weigh the risks and rewards of each stock before making a decision. Typically, the higher the potential reward, the higher the risk associated with investing in that stock.
- Build a diversified portfolio that includes a variety of different types of stocks:
Top-down analysis is most successful when investors use it to build a diversified portfolio that includes a variety of different types of stocks. This can help to reduce the overall risk of the portfolio and increase the chances of earning positive returns.
Picking the Right Sector in a Top-Down Analysis
Once you have the ideal place, sector, or industry for your analysis, you can then begin to pick the right sector. One of the most common ways investors choose a sector is by looking at recent growth numbers and picking a sector that has grown faster than others. Another way to choose a sector is by looking at the economy as a whole and identifying which sectors are expected to do well. This can be done by looking at indicators such as interest rates, inflation, and GDP. Remember that even though certain sectors may be growing, not all stocks in those sectors will be good investments. You still need to do your own research to find the best individual stocks to add to your portfolio.
Top-Down Analysis in Action
Let’s suppose that you are running a business and want to identify companies that might be good investment opportunities for your company’s 401(k) plan. You decide it would be helpful to begin by looking at general economic trends, so you conduct an analysis of how the economy is performing overall. You notice that growth is expected to be slow in the next year, which might make it difficult for some companies, such as those involved in retail. But you also determine that changes in technology and social media could help some companies do well during a time of lackluster growth. So, using top-down analysis, you identify the technology sector as one that might have the greatest potential for growth in the year ahead. You also notice that technology stocks are highly volatile, so you decide to drill down even further by looking at individual companies within the sector. After some research, you find a few small biotech companies that seem promising. You weigh their risks against their expected returns and determine that you believe they could be successful enough to add to your portfolio.
When you are doing top-down stock analysis, remember that macroeconomic forces are the foundation on which the entire analysis is built. These forces need to be taken into account before individual companies can be analyzed. Once you have evaluated the economic climate, it’s time to weigh the risks and rewards of different sectors or industries against each other. After that, you can begin to look at individual companies and make decisions about whether or not to invest in them. Remember that top-down analysis is most successful when it is used to build a diversified portfolio of stocks. This will help to reduce the overall risk of your portfolio and increase your chances of earning positive investment returns.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.