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There's a bias some of us investors have that's programmed into our human psychology, and we must actively fight it: looking at past returns to try to determine the future. This can lead to fearing past growth or becoming enticed by dramatic falls. As irrational as it might sound to our brain, what goes up can keep going up, and vice versa. And if we don't challenge this bias, we could miss out on some great buying opportunities -- as well as chances to sell.
There's no gravity in the stock market
One technology that has caught investors' eyes this year is 3-D printing, leading to enormous stock gains from such companies as 3D Systems (NYSE: DDD ) and Stratasys (Nasdaq: SSYS ) . If you bought shares early in the year, you would've netted a gain of about 230% for 3D Systems and about 150% for Stratasys:
But what if you didn't jump in early in the year? Let's say you were looking at these two stocks during late November. If you looked at the history of the stocks for the year, it'd be difficult to think they had any more room to run, with both up over 100% already:
But if you ignored the past returns, and our human bias, and bought shares in late November, you'd still have meaty returns for both beating the market:
By November, both stocks already doubled over the year, and many investors wouldn't have dared put money down on such high-flying prices. But many would be wrong. After several analysts initiated coverage on 3D Systems and rated the stock as a "buy" in December, its shares ended the year strong, likely inspiring investors to grab shares of Stratasys as well.
Let's look at the opposite case.
There's also no buoyancy in the stock market
What if in April you thought about investing in some social media with Zynga (Nasdaq: ZNGA ) or Groupon (Nasdaq: GRPN ) ? You check the stocks later in the month, and realize both prices are off by more than 35% since the start of April. A value, perhaps?
Unfortunately, even with those April declines, both stocks continued to fall. If you'd based your investment on those declines, you would have ended up losing even more:
There is no rule that stocks return to their previous prices. And with Groupon's and Zynga's questionable futures, they might never return. Groupon is ramping down marketing spending, and is looking for new revenue through selling goods instead of coupons. Zynga struggles to push out games that remain consistently popular, as the fast cycle of social gaming is difficult to keep up.
What to pay attention to
A stock price is the easiest number to dig up for any company, but as a number it means very little when evaluating investments. It's really about what underlies the stock price, what gives that company value, and whether the market has under- or overpriced that value.
There are plenty of ways to value a company to see if the market is mistaken. Take a look at a rundown of the various ways here, where you can learn earnings-based valuation, revenue-based valuation, and cash-flow based valuation, for starters.
Beyond the balance sheet, check out what can't be easily measured through numbers. For example, take time to evaluate a company's leadership and its competitive advantage. Betting on management can give you a chance to buy into a company before others take notice of the improvement in quarterly reports, and a solid competitive advantage can ensure future returns.
For example, Yahoo!'s (Nasdaq: YHOO ) new CEO, Marissa Mayer, has implemented plenty of changes to help move the company toward a sustainable future, and the stock has risen about 25% even after the latest quarter revealed a decline in operating income of 14%. Of course, Yahoo!'s market position should raise concerns from investors, as it just holds on to its 12% search traffic market share and is expected to earn less market share of digital ad revenue, falling from 9.6% in 2011 to 6.9% in 2014, according to eMarketer.
What definitely doesn't matter, though, is Yahoo!'s past price history -- except insofar as it helped determine what its share price is today compared to its intrinsic value.
It takes work to invest
As much as investing research is portrayed as looking over graphs and charts, a practice known as technical analysis, those pictures can burn you and your money. It's much better to rely on deeper research of a company rather than a quick look at its past prices. And if that work seems unenjoyable or too time-consuming, investing in single companies might not be for you. But there are still plenty of index funds to help you grab a piece of the market.
For an example of the type of in-depth research an investor should do, check out our premium report on 3D Systems.
To help investors decide whether the future of additive manufacturing is bright enough to justify the lofty price tag on the company's shares, The Motley Fool has compiled premium research on whether 3D Systems is a buy right now. In our report, we take a close look at 3D Systems' opportunities, risks, and critical factors for growth. You'll also find reasons to buy or sell, and receive a full year of analyst updates with the report. To start reading, simply click here now for instant access.