That’s why if you decide to invest in the stock market, one of the first things you need to do is to determine your trading strategy and how you’ll analyze the markets to choose the companies to add to your portfolio. One of the most popular ways to identify great stocks is using top-down investing, which looks at the big picture before focusing in on the most promising sectors and companies to make better investment decisions.
Since the pandemic peak, travel and outdoor leisure activities have been banned (or greatly reduced) to limit the spread of Covid-19. Consequently, some sectors have crashed, while others have skyrocketed. If you used the top-down approach to determine major macroeconomic trends and significant market developments, you would have 1) quickly avoided airline companies like American Airlines, and 2) turned your attention to home entertainment companies like Netflix, or companies offering online sports betting and casino gaming, like GNOG stock.
Let’s have a closer look at the top-down approach to see how you can use it to maximize your profits and minimize your overall risk.
What is top-down investing?
The top-down approach focuses first on macroeconomic factors, political drivers, sentiment drivers, as well as geographic factors, before examining specific sectors and companies. It is, therefore, easier for investors to spot current trends and allocate funds in the highest-performing industries or regions to outperform the market.
Growth, inflation, employment, monetary and fiscal policies, government investment plans, consumer spending, trade balance, as well as currency rate among others, are some of the most important macroeconomic factors that investors look at to determine the direction of a given economy and which sectors might outperform the market in the future.
When analyzing which stocks to pick in the best sectors, investors can either use technical analysis or fundamental analysis. The first method requires analyzing the price action to determine the main trend and key price levels to decide when to buy a company, while the other requires finding out the intrinsic value of a company to determine if the firm is currently under or over-valued by the market.
Should you choose top-down investing?
When investing in the stock market, investors should always consider the overall market environment and outlook to determine the stage of the economic cycle that we’re in – either expansion, peak, contraction, or trough.
That’s why the top-down analysis is a great approach to adopt, as it will be easier for you to find the sectors and regions with the highest growth potential by taking first into account the big picture. Then, you only have to narrow down your research to find the most promising companies within these performing sectors or countries.
Depending on your risk appetite and your strategy, you can filter the companies according to different kinds of factors, such as market capitalization (blue chips, mid-caps, small caps, penny stocks) or valuation type (growth stocks, value stocks) for instance.