Earnings season: It happens every quarter, like clockwork, yet many investors still get surprised by it. In recent years, earnings season has become a make-or-break time for many companies.
Personally, I’ve experienced both sides of the coin. Sometimes I’ll be on a relatively hot streak, with my stock holdings acting well, but one or two big gaps down on earnings takes away weeks worth of gains. But I’ve also seen my portfolio acting like a stick in the mud, only to shoot ahead and produce great profits as a couple of my holdings gap higher.
A couple of years ago, I spent lots of time trying to examine the characteristics of stocks that gap up versus gap down on earnings, but I haven’t unearthed anything consistent. Said another way, it’s all pretty random.
So how should you play earnings season? There is no one, perfect way. But I’ll highlight the good and bad of three different, realistic scenarios.
Option 1: Ignore earnings reports, and just buy and sell as you normally do. In the long run, this is likely to produce your best results, as good companies in good market environments will, more often than not, react well to their earnings. However, this method will also produce plenty of swings in your account–big drops will be painful, while big gaps up will be terrific. You have to be mentally prepared to see your account drop a few percent within a week or two (regardless of what the market does) because a stock or two was crushed on earnings.
Option 2: Sell part of every growth stock you own before it reports earnings. Believe it or not, this is a decent half-way measure … if you’re running a concentrated portfolio. For instance, if you have, say, 12% of your account in a stock that’s about to report, maybe you trim that down to 6% or 8%. Doing this across the board will lessen your portfolio’s swings, and might actually make it easier to weather earnings season as a whole.
Option 3: Sell most or all of the shares of a stock you don’t have much profit cushion in. Thus, let’s say you own three stocks, one with a 50% profit, one with a 10% profit, and one with 2% loss. In this option, you might hold on to your big winner, because you’re playing with the market’s money, and you’re attempting to build it into a bigger winner. But you also might sell some shares of your 10% winner, because there’s not much cushion there (a gap down could eliminate all of your profit), and you might sell all of the shares of your loser, thinking that you don’t want to risk losing a bunch of money should things go awry.
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Option 4: This one has nothing to do with selling stocks ahead of earnings season—it has to do with buying. Simply put, if a volatile growth stock is going to release results within a week, don’t buy it, or don’t buy much. The thinking is that you won’t have enough profit cushion before the report is released; it’s more like gambling than investing.
None of these methods is “correct,” as what really counts is getting a method that will keep you from freaking out during earnings season, or make you so uncomfortable that you’ll fail to stick to a game plan. Personally, I see nothing wrong with taking some chips off the table ahead of earnings reports, and I usually try to avoid taking a major position right in front of earnings.
But that’s just me—as I wrote above, I detest losses, and generally prefer a smoother equity path (fewer ups and downs). I know a few great investors who simply hold on through all earnings reports, never adjust their strategies and do just fine…albeit with lots of volatility.
So my advice for you as we head into fourth-quarter earnings season is to do some mental homework. Examine your portfolio and pretend that one of your stocks gaps down 20%. Then compare that feeling (and monetary damage) with the one you’ll have if you sell half your shares in a stock the day before it gaps up 20%. Determining which one you can tolerate better will tell you what strategy to pursue during earnings season.