I am convinced that those investors who will do the best are those that know two primary things: 1) human nature and 2) basic business valuation. You can go to business school and learn the latter, while the former is nearly free to those who are paying attention. The advantage you have as an investor—and why I recommend everyone do their own investing—is that the free skill is by far the more important skill. Knowing how to value a business is of limited use because even tiny changes in assumption can have drastic impacts on the results. Highly educated specialists whose livelihood is business valuation will give results that vary widely, based on different assumptions they make. The track record of "pros" is awful.
Yet there are many investors who know very little about the vagaries of business valuation that still do just fine investing their own money because they understand group psychology and how people behave when lumped into large groups.
Let me state this idea more emphatically: your success as an investor depends on your ability to deviate from the group's consensus. This is because the current price of a given stock or any asset is essentially the consensus of what it is worth. If you are to make money, you must have a difference in price occur; you must be able to buy or sell at a price different from the "consensus" in order to make money.
Fortunately, the "consensus" in the stock market moves around a lot, providing a chance for price differentials and profit opportunity. Apple was once worth over $700 per share, and some people (or institutions) actually bought the shares at that elevated price. We know that because in order for that price to be in the record, a transaction had to occur and that means both buyer and seller agreed at that price. Apple now trades less than $600 after recovering from a massive collapse below $400. Why the valuation get so high?
It's for the same reason that valuations for anything can get so high—human nature. People get caught up in the excitement. Consider the interesting article here for additional commentary. From the Dutch Tulip Bulb craze to the South Sea Bubble, to the dot-com bust of 2000, it's only different in degree, not in kind.
Forget about the "wisdom of crowds"—most groupthink in the world of finance is wrong. In fact, all of it is wrong—the only question is how wrong and in which way it is wrong. The problem is that is appears correct.
When a much-touted company goes public, a lot of demand for the shares drives the price higher. Classical economics teaches that if price goes higher, then demand should be reduced (subject to elasticity). In the world of investing, however, demand often increases due to an increase in share price. The weaknesses of humanity cause us to believe that if it is rapidly going up, that it will continue to go up. This effect persists long after the valuation has left all semblance of sanity behind.
Consider for a moment the case study of LinkedIn, a popular social network for professionals, with just over 300 million users. The company (trading under the NASDAQ: LNKD) most recently posted a quarterly loss of $13.4M. The company is losing money now after recently being profitable; the previous quarter showed net profit of $3.7M. For sake of illustration, let's go back a quarter to that $3.7M profit and ask: how much is LNKD worth?
Traditional valuations for stable (slowly growing or not growing) companies is about 15 times the previous year's profit. That would mean that LNKD would be worth about $55.5M as a company, plus or minus about 20%.
LNKD, however is not valued at $55.5M, but rather (as if this moment) $16 Billion. If LNKD grows its earnings at 30% per year, it will still take over 23 years of growth for LNKD to achieve its present valuation. If the growth rate is 50% per year it is still over 14 years of growth. No company in documented stock market history has growth at 50% for 14 consecutive years, never mind 30% for 23 years.
LNKD is not only overvalued for a growth company, but recall now that it recently switched from being profitable to losing money, and that loss was over triple the amount of profit of the previous quarter. It's possible that LNKD is now having to grow expenses much faster than revenue, which all but eliminates any foreseeable possibility of achieving the growth already priced into the stock.
If we charitably give LNKD a value of $100m presently (in spite of the loss), that would still represent a loss of over 99.99% in present share price—meaning its present share price of $152 would drop to less than $1 per share. Yet every day, millions of transactions for LNKD include paying the price to buy at the current valuation, betting that it will go even higher than the stratospheric price it already commands, because—as expensive as LNKD is at $152 per share—it recently traded at highs of $257!