In the movie Blast From the Past Adam (Brendan Fraser) grows up in a bomb shelter and at an age of 35 he goes out for the first time. Of course he gets stunned when he sees the blue sky and just looks admirably at it. When the people around him on the street see this, they start to look up in the sky as well, of course very confused as they don't spot a thing. If you think about your daily life I'm sure you'll find plenty of examples of actions you make, or opinions you get, unconsciously as a result of the people around you (and even media).

Of course crowd following has its advantages. Socially it would be a disaster if you broke the norms of human interactions. Also, to instinctly follow other people might save you in an emergency, however it might also lead to an unnecessary tragedy. Financially crowd following, also called trend following, is something I believe most often to be unwise.

All kinds of crowd following have a cost and an expected gain. Crowd following is always the best decision when the expected gain is larger than the cost.

The cost side of crowd following is usually easy to estimate. The flamingo will lose a small amount of energy every time it escapes. The potential gain is survival. However the chance of actually being eaten if it does not escape is grim. Firstly there are tons of flamingoes in a crowd, and an individual flamingo's chance of being caught is therefore small. Secondly there are probably an overweight of false alarms. The expected gain is in other words the potential of surviving adjusted for the probability of being eaten and the rate of false alarms.

As the eco system is a zero-sum 'game', where all the energy has been produced by plants, all the animals will fight over this limited amount of energy. Therefore I think the different species have evolved into a behavior which maximizes the amount of energy obtained by the specie (i.e. maximize the number of animals multiplied with the size per animal). This equilibrium will last for thousands (or millions) of years, only periodically disturbed by changes in the weather, diseases, change of climate etc (read the article 'Survival of the Unfittest' below to see why the equilibrium eventually will change).

Back to the flamingoes. These animals will have the same marginal energy cost ('MEC') by escaping as the expected MEC of not doing so. The MEC for one individual flamingo escaping is constant, but the MEC for not escaping depends on the crowd's size and the rate of false alarms. A larger crowd means lower MEC by not escaping, but an increasing rate of false alarms has an opposite effect. Evolution has by trying and failing found the perfect solution to the equation.

The markets are just the same way. In the nature the battle is for energy. In the markets the same is true for money. The similarities are as follows:

Because the perfect balance in markets probably doesn't exist, and I believe the participants have a tendency of underestimating the cost of trend following, there is a huge inefficiency in the markets. By buying a stock you have to pay commissions. This is a small cost, comparable to the cost a flamingo has when it escapes. However the major cost of buying when everyone else is buying is the increased price you'll have to pay. If you follow a trend the price all ready has moved up at least something like 10%. Do you think a crowd of flamingoes is willing to give up 10% of its energy to save an expected .2 flamingo (given 4 out of 5 alarms are false)?

Of course there is also an expected gain of trend following. As a single participant you have an extremely limited ability to gain and analyze information. By watching what others are doing you may very well be getting an edge. For example a stock company which is popular among the insiders has most probably a bright future. But is the gain larger than the cost, where the cost is the difference between the prices you and the insiders pay?