Earnings season is underway as investors digest quarterly reports and analysts adjust their forecasts for the quarters to come.
Earnings season is an excellent opportunity for investors to tune in to management commentary, whether that's through a conference call, webcast, or an earnings call transcript (or all three). But it's also a time of heightened volatility and sharp gyrations in stock prices.
With so much noise, it's easy to make mistakes. Here are three big mistakes to avoid this earnings season.
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Evaluating earnings without context
Any company can report a bad quarter or two. Taking an earnings report out of context is a big mistake that can lead to missing out on a buying opportunity or selling at a bad time. Sometimes a stock will go down after an earnings report because the company missed expectations even though the numbers themselves are good. Or the quarter was good, but the guidance is poor. And maybe the guidance is poor only relative to the performance so far this year or last year.
Taking an earnings report and weaving it into the broader context of the investment thesis ensures that a given 13-week time period isn't exaggerated. For example, Microsoft (MSFT -0.12%) stock has been under pressure since the company's Q3 2022 earnings report, even though the numbers themselves were impressive and the underlying investment thesis and long-term growth prospects remain intact.
It's essential to remember that Wall Street can operate on a shorter time horizon, and therefore, is prone to knee-jerk reactions. A hedge fund may lose clients for a bad performance year, or a C-Suite executive may be replaced if the company's stock price fails to meet expectations. As an individual investor, you have the luxury of operating on your own timeline and your own standards. And for that reason, you can take an earnings report and digest it within the context of a multi-year holding period.
Panicking
Panic buying and panic selling are dangerous temptations. On the upside, investors may have a fear of missing out (FOMO), which can lead to overpaying for stocks. On the downside, day after day of flashing red may lead to selling a position at the wrong time.
We can't control our emotions in the moment. But we can make a plan so that when the unexpected happens, we are ready for it. One way to reduce randomness is to dollar-cost average into stocks you like over time. Dollar-cost averaging involves gradually accumulating shares of companies by setting aside a certain amount of investable dollars every period -- such as every two weeks or every month.
When stock prices are higher, those dollars won't go as far. But when stocks are on sale, an investor will be able to accumulate more shares for the same amount of money. The advantage of dollar-cost averaging is that it avoids market timing, prevents panicking, and essentially automates the trading side of investing. An investor may not get the best deal all the time. But they'll likely avoid the big mistakes that come with panic buying and selling.
Anchoring a stock's price to prior highs
Some stocks are down over 90% from all-time highs in the last year or two alone. And many more have suffered losses that are well above the drawdowns in the S&P 500 or Nasdaq Composite. And while many of these stocks could recover from the lows, it would be a mistake to assume that they could return to their all-time highs -- ever. Just because a stock was a specific price at a certain point in time doesn't make that price fair or accurate. Mispriced assets are a common occurrence in the stock market. It cuts both ways, on the upside and the downside.
Unlike other asset classes, the stock market is unique because it is highly liquid, and prices are quoted in real-time, five days a week. As an individual investor, you don't have to agree with or even pay attention to the real-time price unless you want to.
When you buy a share of a company in the first place, it's best to do it for a specific reason that doesn't just depend on thinking the stock price will go up. Maybe it's for a steady stream of passive income from a growing dividend. Or for an exciting new product or service, to invest in a new market, sector, or geography.
The point is that it's not a good enough reason to buy a stock simply because you hope it can get back to an all-time high. Many of the all-time highs over the last couple of years were achieved under conditions that included a unique blend of low interest rates, speculation, and a booming economy. Ultimately, a company derives its worth from what it owns and the future cash flows it will produce. Doing your own research and developing your own reasons for buying a stock independent of prior price action can help you avoid a big mistake.
Use this earnings season to your advantage
Understanding the advantages and disadvantages of an earnings report and its effects on a stock's price stock can help you navigate volatility and stay level-headed.
Wall Street's reaction to a good or bad earnings report often has more to do with the short-term results and less to do with the multi-year investment thesis.
However, it's important to remember that the investment thesis can change due to deteriorating fundamentals. Tuning into earnings reports is a great way to make sure the company is on track to hit its goals.
