Prices and the wisdom of the herd

I often focus on the primal role of prices. There is clarity when you focus on price information. If the price goes up and you have a long investment, you are right. If the price goes down, you are wrong. Given the mark to market process in futures, everyday is a settling of scores. Prices provide important  information and signals. This is especially true when investors are facing a significant amount of uncertainty.

When faced with more uncertainty or a shortage of good information, the only good choice is to follow the crowd.  Some have described trend-followers as non-informed traders who could destabilize price. The same could be true of those who are over confident about their ability to discount information. Following prices is just one form of decision-making when there is limited confidence in the link between fundamentals and price.

What does it mean to follow the crowd? Some think that is this listening to what the talking heads on the business news channels are saying, but that is far from the truth or the crowd. The wisdom of the crowd is right in front of any investors when he looks at prices. The price embeds all of the information of the crowd.

If an investors is faced with period of market uncertainty and a lack of information, it is useful to then rely on prices as a key source of information. These periods of uncertainty will be the best time to follow the trends. This provides one line of reasoning for why trends are more prevalent during period of uncertainty.  There is clear rationality with following the herd through the behavior in prices as a means of following market weighted opinions.

That said, we also know that prices cannot incorporate all information. Simply put, if prices provide all market information, their would be no reason to collect information. This is the old Grossman-Stiglitz puzzle. Prices will not represent the discounting of all information. That may take some time and repeating regularly.

Following the price is following the crowd, but that crowd represents the aggregated wisdom of all players willing to commit capital trading. It can be wrong, but it clearly is a primal source of information.