Top-down and bottom-up approaches are methods used to analyze and choose securities. However, the terms also appear in many other areas of business, finance, investing, and economics. While the two schemes are common terms, many investors get them confused or don't fully understand the differences between the approaches.
Each approach can be quite simple—the top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general. These methods are possible approaches for a wide range of endeavors, such as goal setting, budgeting, and forecasting. In the financial world, analysts or whole companies may be tasked with focusing on one over the other, so understanding the nuances of both is important.
- Top-down usually encompasses a vast universe of macro variables while bottom-up is more narrowly focused.
- Top-down investing strategies typically focus on exploiting opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
- While top-down and bottom-up can be very distinctly different they are often each used in all types of financial approaches like checks and balances.
Top-down analysis generally refers to using comprehensive factors as a basis for decision making. The top-down approach seeks to identify the big picture and all of its components. These components are usually the driving force for the end goal.
Top-down is commonly associated with the word "macro" or macroeconomics. Macroeconomics itself is an area of economics that looks at the biggest factors affecting the economy as a whole. These factors often include things like the federal funds rate, unemployment rates, global and country-specific gross domestic product, and inflation rates.
An analyst seeking a top-down perspective wants to look at how systematic factors affect an outcome. In corporate finance, this can mean understanding how big picture trends are affecting the entire industry. In budgeting, goal setting, and forecasting, the same concept can also apply to understand and manage the macro factors.
In the investing world, top-down investors or investment strategies focus on the macroeconomic environment and cycle. These types of investors usually want to balance consumer discretionary investing against staples depending on the current economy. Historically, discretionary stocks are known to follow economic cycles, with consumers buying more discretionary goods and services in expansions and less in contractions.
Consumer staples tend to offer viable investment opportunities through all types of economic cycles since they include goods and services that remain in demand regardless of the economy’s movement. When an economy is expanding, discretionary overweight can be relied on to produce returns. Alternatively, when an economy is contracting or in a recession, top-down investors are usually overweight to havens and staples.
Investment management firms and investment managers can focus an entire investment strategy on top-down management that identifies investment trading opportunities purely based on top-down macroeconomic variables. These funds can have a global or domestic focus, which also increases the complexity of the scope.
Typically, these funds are called macro funds. They make portfolio decisions by looking at global then country-level economics. They further refine the view to a particular sector, and then to the individual companies within that sector.
Top-down investing strategies typically focus on profiting from opportunities that follow market cycles while bottom-up approaches are more fundamental in nature.
The bottom-up analysis takes a completely different approach. Generally, the bottom-up approach focuses its analysis on specific characteristics and micro attributes of an individual stock. In bottom-up investing concentration is on business-by-business or sector-by-sector fundamentals. This analysis seeks to identify profitable opportunities through the idiosyncrasies of a company’s attributes and its valuations in comparison to the market.
Bottom-up investing begins its research at the company level but does not stop there. These analyses weigh company fundamentals heavily but also look at the sector, and microeconomic factors as well. As such, bottom-up investing can be somewhat broad across an entire industry or laser-focused on identifying key attributes.
Most often, bottom-up investors are buy-and-hold investors who have a deep understanding of a company's fundamentals. Fund managers may also use a bottom-up methodology.
For example, a portfolio team may be tasked with a bottom-up investing approach within a specified sector like technology. They are required to find the best investments using a fundamental approach that identifies the companies with the best fundamental ratios or industry-leading attributes. They would then investigate those stocks in regards to macro and global influences.
Metric focused smart-beta index funds are another example of bottom-up investing. Funds like the AAM S&P 500 High Dividend Value ETF [SPDV] and the Schwab Fundamental U.S. Large Company Index ETF [FNDX] focus on specific fundamental bottom-up attributes that are expected to be key performance drivers.
Generally, while top-down and bottom-up can be very distinctly different they are often used in all types of financial approaches like checks and balances. For example, while a top-down investment fund might primarily focus on investing according to macro trends, it will still look at the fundamentals of its investments before making an investing decision.
Vice versa, while a bottom-up approach focuses on the fundamentals of investments, investors still want to consider systematic effects on individual holdings before making a decision.
How do you take in the world around you? Do you sense what’s going on, or do you use perception to organize and interpret information?
These are big questions. Sensation and perception explain how we recognize our friends when they approach us, how we form memories, and how we analyze what is going on at any given point in time.
Bottom-up processing is the idea that we begin to perceive items with sensation, as opposed to our conceptual ideas. This process is also known as “data-driven processing,” because it is just that: driven by the data that we collect with our senses.
Right now, you see a computer screen and some animations. But before you could recognize the computer, you took in the individual parts of the computer: the shape of the machine, the light emanating from the screen, each of the keys on the keyboard, etc.
Some psychologists argue that sensation and perception are two different processes. Some argue that they are exactly the same.
We call these theories “bottom up” and “top down” processing. One argues that sensory and perception are the same, and that we process stimuli first and analyze it later. The other is a “top down process” that starts with memories, expectations, and motivations. We apply our knowledge and expectations to create a backdrop for our world as we perceive it, and then begin to focus on the smaller details using sensation.
I’m going to focus specifically on the bottom-up approach to processing and how we process the stimuli that is around us. James J. Gibson developed the theory of bottom-up processing, and his work has significantly impacted the world of psychology, behaviorism, and neurology.
Gibson’s Theory
The theory of bottom-up processing sounds easy enough, but Gibson’s theory on this process is still grounds for debate in the world of psychology. Why? Gibson theorized that no learning is necessary to perceive stimuli. The process from looking at stimuli to analyzing it is a direct line. As the visual stimuli moves from the retinas in the eyes to the visual cortex in the brain, we begin to move deeper and deeper into an analysis of what we are seeing.
This is a reductionist theory. Reductionism is the idea that we break down big ideas into their most basic parts. [This is the opposite of holism, which looks at the “big picture” ideas first.]
When you apply this idea to the nature vs. nurture debate, it is clear that Gibson takes the side of nature. He is arguing that we are solely using nature to perceive the world and analyze what we are seeing. In fact, he is one of the founders of ecological psychology.
Affordances
While Gibson was developing the theory of bottom-up processing, he coined the term “affordances.” Everything we see has a number of affordances, or different opportunities to interact with the item.
An affordance is a thing that offer something to the perceiver more than what it specifically is. For the simplest example, a chair is a construction of wood, however it 'affords' us the opportunity to sit in it.
These affordances include:
- Relative brightness or size
- Texture Gradient
- Height
- Highlighted objects
Gibson argued that the idea of affordances were crucial to the idea of bottom-up processing. He theorized that when we were looking at an item, we observed its particular affordances.
Examples of Bottom Up Processing
One simple example of bottom up processing is when you are walking to a friend's bathroom in the middle of the night. You have to turn the light on to see where you are going, instead of using your memory of where things are in the bathroom.
Below are some more examples of bottom up processing in everyday life:
1] Interpreting Road Signs
One of the ways that affordances works to support the theory of bottom-up processing is road markings. Road markings use several different affordances to communicate speed requirements and the direction of the world. As you’re driving along a country road, you are not working from the top down - you are sensing the signs on the side of the road and on the road to determine where you are going and how fast you are going.
2] B or 13?
This next example is a two-part example that shows the difference between bottom-up and top-down processing.
Using bottom-up processing, you might look at the middle symbol and say it’s a “B.” Sure, you have learned what a “B” is in the past. But you did not need any context to look at the markings, send that stimuli to your visual context, and analyze the stimuli to determine that the markings were the letter “B.”
Top-down processing may yield a different result. Let’s say those two markings were placed between a “14” and a “12.” When you come across the two markings, you recognize it as “13.” You expect the markings to be numbers based on the knowledge of what else is on the page. After some time, you might change your mind. But your initial perception of the markings was different than a letter “B” due to top-down processing.
3] Prosopagnosia
Bottom up processing can feel like a hard concept to grasp, especially if you find yourself thinking that your past experiences and the things you have learned are crucial to understanding the world around you. This is why so many psychologists align their thinking with the idea of top-down processing. But by looking at a condition in which the ability to use top-down processing is missing, you can better understand bottom-up processing.
So let’s look at Prosopagnosia.
Oliver Sacks is a well-known neurologist. His list of books include The Man who Mistook His Wife for a Hat. [If you’re interested by anomalies in the world of neurology, I highly recommend this book!] Sacks himself could distinguish his wife from a hat, but he had trouble distinguishing other people’s faces, even the ones he knew. He had Prosopagnosia, which is also known as face blindness.
Patients with Prosopagnosia don’t use top-down processing to identify individuals. They are able to take in what they see when they look at a person’s face. They can identify whether the person has freckles, blue eyes, or a crooked nose. But they can’t identify whether or not they have seen that face before, or who it belongs to.
The process in which people with face blindness take in the faces of others is an example of bottom-up processing.
4] Bottom-Up Tests and Assessments
How do you know how someone is feeling? They could tell you. Or, you could get clues from how the person is acting and put together your final judgement. Many professional therapists use the second approach in tests and assessments. These are called “bottom-up assessments” because they resemble the bottom-up process.
Bottom-up testing and approaches vary depending on the type of therapy that is being practiced. For example, a cognitive behavioral therapist might ask their patient a series of questions about a memory or a subject. They listen to what the patient has to say, but also observe what is going on in the patient physically [sweating, fidgeting, etc.] They use this input to make their assessment.
5] Blind Taste Test
Have you ever seen someone do a blind taste test? Maybe they were a judge in a cook-off or they were on a game show and had to guess what they were eating. They can probably guess that they are eating food or have other clues about what they are going to put in their mouth. But they must use bottom-up processing to assess what they are eating. The taste buds help the brain with this - they send sensory information to the brain with little or no context. From there, the brain has to do the work to figure out what the person just ate.
6] Sensing a Fire Far Away
But you don’t have to be “blind” or have your eyes shut to use bottom-up processing. Let’s say you’re in the woods. You see all of the trees around you, but nothing else looks unusual. All of a sudden, you hear some popping noises. You smell the faint smell of smoke. After a while, you start to feel that one side of your body is exposed to heat. All of this together tells you that there is a fire nearby and it might be time to run or see if everything is okay. Your eyes can’t see the fire yet, but bottom-up processing with the help of your other senses tells you what is going on.
Have you all of a sudden felt strange stomach pains “out of nowhere?” You have to use bottom-up processing to figure out what is causing your symptoms. The first clue that something is not right is your sensory experience. From there, you have to think about how you are feeling mentally or if you ate something that could have caused the stomach pains.
You have to draw from past experiences where you might have felt similarly. If you anticipate the stomach pains due to an allergy or situation that may cause stomach pain, you may be using top-down processing to assess your symptoms.
To sum up the idea of bottom-up processing, James Gibson proposed a theory saying that the process of analyzing stimuli is a direct line between the stimuli around us and the parts of the brain that analyzed it. No further learning influenced what we perceive.
While it may feel like we interpret road signs, make assumptions, or read images automatically, there is some work that goes into bottom up processing. Of course, these skills get much faster as we interact with the world around us!
Is Bottom Up Processing The Same As Inductive Reasoning?
Many students confuse bottom-up processing with inductive reasoning - but they aren't the same! Inductive reasoning and bottom-up processing are often linked because they take from past information and experiences, but it's important to know that they are a similar means to a different end.
Take a look at what Brainvoyager135 shared when this question was asked on Reddit:
"It's not a bad way to help you memorize the concept, since connecting is important. However processing and reasoning are not synonymous. Processing is all about sensation and perception. Reasoning is about theories and observations."