If a stock you have been holding for the long term drops significantly after its earnings announcement, you have three choices:
1. Buy more stock at a cheaper price
2. Do nothing
3. Sell
Buy more
The argument for buying more is that the stock is now cheaper. The unusually large drop may have been a market overreaction, meaning there’s now a buying opportunity. On the other hand, if you bought the stock based on certain criteria, such as expectations about growth, earnings and profits, the earnings report may tell you that those metrics have changed. Any buy decision should also be based on a comparison with other stocks. A company that responds poorly to an earnings announcement is rarely going to be one of the best buying opportunities around.
Do nothing
Your second option is to do nothing. This may be a strategy if you had bought the stock to buy and hold until retirement. However, you should review a stock after 12 months or after a fall of 25% from its high since it was purchased to consider fresh, relevant information. This gives you a good balance between avoiding to trade every single news and ignoring relevant and changed information. This way you do not get blindly locked into multi-year investments that do not perform. “Buy and hold” is one thing. “Buy and hope” is another!
Sell
This is a difficult choice for most investors because a loss is not just a loss of money but many investors also a blow to the ego. A loss is also difficult to take because many investors feel that they need to win on every investment and are determined to keep a good (near 100%) record. But important is not the number of winners but how much money you make and then keep. The two are not always linked. Traders can win 9 trades in a row, only to lose all those gains or more on their 10th trade.
There are many reasons to sell a stock but there is one overriding rule that should be used in order to limit downside risk. The rule is not to hold more than 5% of your stock portfolio in one single stock and place a 25% trailing stop.
With this type of downside protection you do not only limit your risk of an individual stock to a very small portion of your overall portfolio but you can go through prolonged losing streaks without fear that you will exhaust your capital.
Prices jump or fall. Price drops are usually unexpected. That’s why you need to have your strategy in place before prices fall. Be prepared and have a plan of action, so you don not get caught in the emotion of the moment.
As the markets go higher, investors should expect more and more volatile moves soon. That’s when a strategy is needed more than ever. In a rising market, everyone is a genius. But it’s not about how many winners you have got. It is all about how much you make and then keep.
Sven Franssen