Often times you will hear certain types of investors talk about how looking back at a stock’s chart to determine what it will do in the future is comparable to driving forward while looking in your review mirror. While I understand their point, the analogy is only partially right. When I drive, the road behind me is left behind. My vehicle is independent of the previous pathway it traveled. The past movements of stock price and volume are a representation of where investors bought or sold. Since not everyone is a day trader, knowing where large amount of stock was bought in the past can help you gauge where selling and buying pressure might ensure at a future time.
To illustrate why past stock performance matters in the present and future, let’s create a scenario. Company D has great earnings and trades up 10% in one day. The stock’s volume, which averages 1 million shares today averages 5 million (+500%) on the day of this price jump. After a few days of more or less sideways price activity, company D begins to loose its ground. For the next couple of months the stock slowly gives up the 10% it gained and returns to where it previously traded. In doing so, you have a lot of investors holding onto an investment that they purchased near the highs of where the stock had traded at. The excessive volume of that day tells us that many existing or new investors bought the stock. Now these investors are sitting around and thinking, “Gosh, I guess that didn’t play out how I thought.” The longer you or I have an investment sitting at a loss, the more eager you are to offload the investment. The purpose of investing is to make money, not lose money.
Fast forward to today, company D has some additional good news and the stock rises by 8% and volume is above average. Do we have any information to go on, outside of the good news the company released that would guide us in our decision to buy or not to buy? Of course we do. It can be reasonably assumed that many of the investors that purchased back when the company initially jumped by 10% are still stock holders. It’s also reasonable to assume that a fraction of those investors are disillusioned with their decision, since the stock didn’t perform as they expected. Therefore, until the stock’s price breaks through the prior selling high we described happening a few months ago, a decent amount of selling pressure could exist. This means that a prudent move for us would be to wait to see if the stock can surpass the prior highs before establishing a position. The stock’s price and volume history does matter on future activity.
Investing is a gamble. We cannot escape this reality. It’s part of life, and when we boil things down, every decision we make in our life has some form or risk or ‘gamble’ component. Through looking at past price and volume action of a stock, we cannot eliminate risk. Yet, we can take steps to help mitigate risk and create a structure in which we are able to manage risk more effectively.
It can be significantly valuable to look back at a stock’s past performance. Driving a vehicle via looking in the rear view mirror is only helpful in short bursts (i.e. changing lanes). Though the analogy sounds good, it’s not an apples to apples comparison.