"The price has dropped -- should I buy?"
That's the question ringing in your ears if you've been thinking about buying shares of Advanced Micro Devices
You're also asking yourself that question if you've taken a long, hard look at Amazon.com
Sure, as an investor, you know the market is a volatile place. But in the face of recent stock drops, you're undoubtedly worried that the prices of these once-great companies will continue to fall.
Too much projecting
Don't worry, you're not just a worrywart -- you're suffering from a little-known investing disease called "extrapolation fallacy." This occurs when events in the recent past are extrapolated indefinitely into the future. In other words, if AMD's stock price has fallen, you think it will always fall. Not so. I hope you can see how silly the extrapolation fallacy really is.
You're not alone in your silliness. Extrapolation fallacy is a common ailment in the market. On a broad basis, it contributes to prolonged bear markets. But it can also work in reverse. It can cause people to assume that things are great, and that they'll always be great, which leads to financial bubbles -- like the dot-com craze of the late 1990s. You know, the one Alan Greenspan dubbed "irrational exuberance."
Good results in the long term
The truth is that stock prices rise and fall, but in general they do more rising than falling. Just take a look at the long-term charts of companies such as Electronic Arts
Electronic Arts was trading at a split-adjusted $1.02 or so in June 1990. As I write, it trades at about $49.30, a return of more than 4,700%. Along the way, however, it declined almost 70% in 1993 and 1994, and it fell 50% from late 1999 to mid-2000. A roller-coaster ride, indeed.
Tech companies aren't alone in their ups and downs. The long-term chart of Caterpillar, for instance, shows increases of several hundred percent -- and declines of more than 50% -- throughout the years. Overall, however, Caterpillar has returned more than 1,600% since 1985.
It's said that history never repeats itself, but it sure does come close. Down trends like the one we're seeing now do not necessarily herald the end of a company. Similarly, up trends will not continue unabated. Whether the company you are interested in is a $147 billion giant like Chevron
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This article was originally published June 22, 2006. It has been updated.