Top down or bottom up?

There are at least two possible approaches to the portfolio selection process that are philosophical opposites but sometimes can complement each other.

On the one hand, the Top Down approach goes from the general—the asset allocation among the macro asset classes—to the specific through increasingly granular categories of financial instruments, ending with stock picking.

On the other hand, the Bottom Up process goes the opposite way, ignoring global trends and focusing instead directly on the outlook for individual stocks. This way, the asset allocation becomes the aggregation of specific decisions concerning individual instruments or relatively small market sectors.

The former suits best long-term portfolios based on the strategic asset allocation, i.e. the one supported by considerations on systemic factors such as the correlations among asset classes or the macroeconomic outlook. The latter is usually the staple of more active and aggressive approaches seeking to track, and sometimes anticipate, short-term trends.

That said, investing strategies often combine different techniques with varying degrees of flexibility. In these cases, investors usually start from an overarching strategic asset allocation to determine the core structure of the portfolio, and then use bottom-up approaches that leverage contingent and/or particular events to temporarily adjust weightings between asset classes.

Luca Lodi
FIDA Research Centre