Rules of the Game: Earnings Don't Matter

 | Sep 30, 2013 | 2:00 PM EDT  | Comments
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I can already hear the shrieks of "heresy" out there. After all, what would the financial media do without endless reports of which companies met, missed and beat analysts' views?

I didn't just drop into the financial services industry this morning. I understand the importance of profitability, and how an index like the S&P 500 is affected by the earnings performance of its components.

As Dimensional Funds has shown recently, adjusting for one-time accounting events (such as a non-recurring expense), a firm that was profitable in the prior year is likely to continue that trend. Dimensional is now introducing new products and modifying existing funds to take advantage of this new research.

Of course, profitability matters. But I'm saying something different: A fixation on earnings reports encourages an emphasis on single stocks, rather than on a well-constructed portfolio designed to match a financial plan.

A collection of single stocks is not a portfolio. It's a group of stories. "Alcoa (AA) kicked off earnings season! What will it portend?"

Who knows? If the world were made up of only large aluminum companies, it could portend a heck of a lot. But the real world consists of companies from all manner of industries, all corners of the world and of all sizes. It's good dinner party talk, however, to do some quick analysis of what one stock could mean for an entire earnings season.

Why not focus on the significance of Cal-Maine Foods' (CALM) upcoming earnings? After all, small-cap and value tend to outperform both large-cap and growth. Wouldn't that be a more relevant obsession? OK, I'm being a bit snarky here. You get that.

But single stocks make for better stories than a group of funds encompassing global asset classes and market cap. It's tempting to say you can diversify risk with single stocks, and maybe a few bonds here or there, but are you really achieving diversification?

I know of growth stock traders who shun any notion of diversification, except for being sure they spread their selections among a few different industries. Why would you willingly forego the expected returns of a whole slew of asset classes?

Let's go back to earnings reports. I'm picking on earnings reports because they represent a specific, closely-watched event. Sure, a stock can soar or plummet on the news, but often the effects are fairly short-lived. The same can be said for analyst upgrades and downgrades, which also get a lot of media attention.

I used to host a stock-trading radio show, and edit a companion newsletter. I was part of the problem, and hopefully my actions these days are enough penance. (Any clue what my childhood religious background was, based on that last sentence?) In my stock newsletter days, earnings, as well as analyst actions and surprise news items on specific stocks held great sway over trading results.

But when you are investing in a diversified basket of funds, those events tend to have negligible effect on your overall portfolio. And that's the way you want it.

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