The reason you shouldn't follow the crowd is for the obvious reason that, having been there, the crowd will already have eaten all the profit there is to be had. That Tail End Charlie in the herd of zebra doesn't get the choicest grass after all.
We can put this in formal terms if we wish. The efficient markets hypothesis says that knowledge is already embedded in market prices. The corollary of this is that it's very difficult to impossible to beat the market. The reasoning here is simple enough.
If people know something then they will trade upon that knowledge. So, the knowledge becomes embedded in prices as a result of those trades. There are variants of the EMH dependent upon who knows and how much they trade, true, but if we've something that all know then that will already be in prices under any variant.
If the crowd knows and is trading it – that's what we might be following after all – then it's already happened. Prices already include that knowledge. That this is formal terms is shown by this all being a recent Nobel Prize – Eugene Fama and so on.
We can also think of this in more logical terms, rather than depending upon economic theory. Say that the crowd knows that Apple (NASDAQ: AAPL) profits are going to be higher than expected.
Well, one problem is that if the crowd does know it then that's what the expectation of Apple's profits are going to be. But even if we leave that aside assume the crowd does act upon that idea.
That will mean Apple stock rises because people are buying in order to benefit from the soon to happen announcement. The price rise happens before the announcement that is, because the buying does. For us following that crowd there is no gain in Apple stock – it's already happened before we buy, because we're following the crowd.
We've also a third method, market folktales. The old advice is to buy the rumour and sell the fact. That is, buy before the price moves, when only a few know or believe. Once the information is common knowledge then prices will move to the new level, which is when we should sell. We've ridden the process of that information becoming embedded into stock prices.
Following the crowd just means that the price changes we're trying to trade have already happened and there's really no point in that at all.
What we actually desire to do as traders or investors is to lead the crowd. This is of course more difficult, as it's not always obvious where the crowd will go nor when. This requires research and sometimes assumptions about the future but no one ever said that profitable investing was easy.
The task therefore is not to follow the crowd, but to work out where the crowd is going to be. At which point we can position ourselves ahead of them. Buy at the prices before the crowd grasps events, sell at the new prices once they have. Or, obviously, if we're going short, sell before they do and buy back after them.
The full and total reason you shouldn't follow the crowd is because it is the actions of the crowd itself which moves markets. It is that buying and selling by other people which changes prices. We want to be there before the crowd and leave as they arrive. We're in Yogi Berra territory that is; “No one goes there any more, it's too popular.”
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