I have mentioned this paradox before, so I thought it deserved some discussion. The Grossman-Stiglitz paradox states:
- If markets are efficient and securities' prices reflect all available information and,
- obtaining information about securities requires resources (time, money)
- Why do people commit resources to researching securities at all, and
- if people don't need to commit resources to researching securities, then how did the prices get right to begin with?
To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.
I remember a discussion with a Carleton finance professor, Mike McIntyre, where I asked him what would happen if everyone started to buy indices and stopped trying to beat the market. Following our discussion, if everyone started to buy indices, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.
At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound interest are in building up wealth.
I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have their fun spending money to make predictions, and they keep the markets efficient for the rest of us. To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.