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Don't Make These Earnings Errors

These three common behavioral mistakes can trip up investors as they digest earnings data, says Fuller & Thaler director of research Raife Giovinazzo.

Don't Make These Earnings Errors

Jason Stipp: I'm Jason Stipp for Morningstar.

Earnings season can provide stock investors with a raft of new information on their stocks, including recent performance as well as forecasts, but how you use that information could be critical to your investing success.

Here to talk about some common behavioral pitfalls around earnings season is Raife Giovinazzo. He is a director of research at Fuller & Thaler and also a co-manager of Allianz Global Investors Behavioral Advantage Large-Cap Fund.

Thanks for joining me, Raife.

Raife Giovinazzo: Thanks for having me.

Stipp: You say several behavioral mistakes may rear their head during earnings season. Let's discuss three of them and how they might play out as people are getting the news about their companies. We are in the midst of earnings season now.

The first one you say is anchoring. Can you describe anchoring and how it comes to play during earning seasons?

Giovinazzo: Anchoring is a rule of thumb that all people use, and that's starting with an anchor, a starting number, and adjusting away from it, but typically people don't adjust enough. It is part of why car dealers will often have a very high sticker price, because they know you'll adjust down as you're thinking about the true price, but you probably won't adjust enough.

To use a hypothetical stock example, let's imagine that last year's quarter, earnings were $1. Let's imagine that the forecast for this year is $1. Earnings come in, and the quarterly earnings, let's say, are the annual equivalent of $1.30. It's a big jump. What people are likely to do is … anchor on the old number--they're going to anchor on the analyst consensus forecast of $1--and they'll say, the sustainable earnings are somewhere between $1 and $1.30. Now that's actually a very good rule of thumb, and that's why people use it. But you can imagine there are going to be times when it's completely wrong, and you're going to miss out on a very big and important earnings surprise, and that's the danger of anchoring.

Stipp: The second effect that we sometimes see in earnings season is called the "disposition effect," and I think this can come into play around earnings seasons, because we often do see stocks re-price based on what their forecast is or based on what their results were in relation to expectations.

Can you elaborate on this disposition effect, and how it may come into play and how we can perhaps work against it?

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Giovinazzo: The disposition effect is a tendency for investors to sell their gains and hold on to their losses, and the reason why is a combination of loss aversion and mental accounting. They really want to get even. They really want to breakeven, get into the positive. And they think, well, if I don't actually ever sell it, then I don't have to actually acknowledge that the stock price has gone down.

Terry O'Dean, a professor at Berkeley, has found that individual investors do this a lot. The problem is, there tends to be price momentum. There tends to be a drift after news for days, weeks, sometimes months. And especially this happens on the downside, that when there is negative news, people who've lost money, the price has gone down, they don't react as they should to that news, because they're trying to stay in long enough to break even. That's the disposition effect.

There is even some research by Andrea Frazzini, who is my dissertation committee member, who has done work that this might be even part of the cause of price momentum. You don't want to be the person who fails to recognize that there is bad news and holds on too long, while prices continue to drift down even further.

Stipp: But also at the same time, though, you don't necessarily want to sell if your thesis is that this could be a short-term effect, right?

Giovinazzo: Yes. It's vital to know which one it is, but what you want to make sure is that your decisions are being driven by cold, hard, rational analysis, not by this desire to pretend that the losses didn't really happen and just make yourself feel good ultimately by not acknowledging that there has been a loss.

Stipp: Or just thinking, I'll wait until it just gets back to the price that I bought at?

Giovinazzo: That's totally common, and we've all done that. You see people do that at a lot of casinos. That's a good way of just testing the general behavior. An interesting tidbit is the last horse race at parimutuel betting situations, the odds go way out of favor on the longshots because it's all the people who lost money throughout the day betting on the longshots trying to get even. People really want to get even.

Stipp: A third behavioral problem that can occur in many parts of our lives, financial or otherwise, is a confirmation bias. So, how do you see this playing out? I think this is a tough one to overcome as you're trying to do good research.

Giovinazzo: It's very tough. It's human nature to look for confirming evidence and to not look sufficiently or ignore disconfirming evidence. People want to find the data that supports their story.

The issue with earnings announcements is, there is tons of other information that's announced simultaneously. There is a forecast for the future. There is discussion of new product development. It's very easy if you want to pick and choose the pieces of evidence that support your investment thesis to pick and choose those pieces and miss the big picture and not really recognize that the facts have changed, your investment thesis was wrong, [and] if you own the stock, it's time to sell.

Stipp: All of this is not to say that you should put your head in the sand during earnings season. This is an important time for new information on the stocks that you own, but there do seem to be several behavioral stumbling blocks. So how can we be better when we're getting all this information, when the markets are moving, to keep a clear head and try to really incorporate earnings in a way that will be beneficial for us as stock investors?

Giovinazzo: Three recommendations:

The first is to try to avoid anchoring, and in particular, what we do at Fuller & Thaler when we see a big earnings surprise is analyze, do we think that this is due to a permanent change in the outlook of the company or something temporary? A lot of times the management will say what they think, but beyond that, common sense often applies. If it's a fundamental improvement in the operations of the business, it's probably a permanent earnings change. You really don't want to anchor [on past performance trends] there. If it's something temporary, where it's a blip in commodity prices or in some cases the weather, that's actually why the anchoring rule of thumb often works, and there you should be thinking about what's been going on in the past.

The second thing is to avoid the disposition effect. It's good to mark-to-market in your mind. When it's gone, it's gone. The rule of thumb, or the old adage in poker is, if you don't want to raise, you probably should fold. I would say in buying a stock, if you don't want to buy it again, if you wouldn't buy it right now, you probably should sell. Now, with that said, there are very important tax implications when you have a sale. The IRS sort of works like, a loss isn't real until you sell it. There can be transaction cost issues. But what you don't want is to be driven by the psychological issues of, I don't want to acknowledge that there has been a loss.

The third issue that we talked about for confirmation bias, it's very hard to avoid. A story I would tell that I think illustrates a good way to handle it is, my first job out of college was as a strategy consultant. The lead partner, when he was reviewing a presentation, he'd first flipped it on the back, and he'd write down, here are the three things I expect to see in this presentation. And then he flipped it back and see, was it in there? The analogy for stocks would be, before the earnings announcement to say what you think you're going to see, and then be very rational and objective about, did you see it, did you not see it? And especially look for markers that you were wrong. Specifically forecast, if I see this, that's a sign that they're not actually turning around the company, or they're not growing as I expected.

So, I hope that's helpful, but those will be my thoughts about how you can look at earnings without succumbing to some of these behavioral biases.

Stipp: Fantastic tips for helping us to keep a level head during earnings season. Thanks for joining me, Raife.

Giovinazzo: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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