You can contrast it with bottom-up investing, which begins by looking at an individual company’s balance sheet and other fundamentals, and branches out from there. A bottom-up approach would look next at the sector or industry level, and then at global market conditions as the final step. As you use the top-down method when you invest, it’s helpful to break the process into three steps. We’ll start large and funnel down.
Choosing a Country
The starting point for a top-down approach is to choose what country or market has the best climate for your investing goals. Emerging markets, which are also sometimes called “developing countries,” often have the highest economic growth rates. But there are many other major factors to think about when weighing countries and choosing which to focus on. Here are a few of the most common.
Geopolitical risk: International investors must assess whether a country’s economy is being put at risk, and whether it presents a risky outlook. This could happen either by its own political situation or by other countries in the region that may be less stable. A neighbor country at war, or a conflict between two or more countries nearby, are sure signs of risk. For example, when Russia annexed Crimea in Russia’s in 2014, it upset the region greatly, including its markets, and increased the risk for all who wished to invest in Eastern Europe.Asset valuations: International investors must also look at asset valuations from within the context of a given country’s economy’s growth. While a rapidly growing economy may breed rapidly growing companies, there’s also a chance that the securities tied to this action will be overvalued. This in turn will have an effect on their profit potential.Disclosures and financial reporting: One more thing to keep in mind if you’re looking to invest in emerging markets is the risk that financial disclosures may be incomplete or even misleading. Though many governments protect their markets with strong regulatory and legal systems, this is not true in all countries.
Aside from these concerns, you should also keep in mind that the strength of a country’s currency can have great impact on your holdings in that country. A foreign stock may seem like it’s posting strong growth rates in local terms, but those growth rates may vanish when you account for the depreciation that happens when you convert the local currency to the U.S. dollar. Unless you’re aware ahead of time, and keep a close watch on shifting currencies, you may only realize the true effect of depreciation once you convert your profits into U.S. dollars at the end of the market cycle.
Choosing a Sector
The next step for those taking a top-down approach is to assess specific industries within a chosen country. In many cases, a country or region will see the majority of its growth in certain areas of the economy, rather than broadly across all segments. These tend to change over a complete economic cycle. There are some patterns that tend to hold true over time though. For example, technology often leads the way, and utilities often lag behind in the cycle. To explain, take a country whose growth is strongly tied to the retail sector. If you invest broadly across all sectors of the economy in that country, you might see lower returns, when you compare it to what would happen if you target those sectors that are growing the fastest, like retail, or which you predict will see the greatest growth in the near future. You should also look at how a country is run at higher levels, and which industries, if any, are regulated or influenced by governments. For instance, some countries provide subsidies to support industries that are important for larger scale trade deals. Or, a country may choose to subsidize an industry as part of a welfare program, such as to support small local farmers who can’t compete with mass production farms. These types of supports and systems might help boost profits in the short-term, but may not be in place for very long. Be sure to dig deep into any sector ties in this stage of your top-down approach.
Choosing Assets
The final step of the top-down investing approach is to take a closer look at the details of a single asset. This could include foreign stocks, American Depositary Receipts (ADRs), international ETFs, or any number of other asset types. On a technical level, you may wish to look for assets that have rising rather than falling prices in order to trade with the trend. Many international investors use this method and ride the wave, so to speak, which doesn’t need expert level timing or massive amounts of research. You may miss out on early gains if you catch a trend, but it’s often a safer way to invest when there are so many unknowns, as there are in risky emerging markets. On a fundamental level, investors may seek out assets that are undervalued when compared to other securities (both domestic and international) of the same asset class and sector. This method assures that you’re not paying too much for a given asset. Lastly, you should look closely at the expense ratios of international ETFs and other funds. Sector-specific funds tend to cost more than most, and demand extra caution. If you’re not aware of how much it costs you to make a trade, or any other fees involved, such costs can eat into your returns before you know it.
