Benjamin Felix January 28, 2014 Advanced Investing The Grossman-Stiglitz Paradox At PWL, we often cite efficient markets as one of the building blocks of our investment philosophy. We believe that because all available information is included in the prices of securities, and new information is random, we are better off capturing the performance of the market rather than trying to identify which company, asset class, or region will be the next big winner. Our market-based strategy is backed by years of data, but if all available information is factored into the prices of securities, someone must be doing the research, right? This is a paradox, and it has a name. 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) Then, why do people commit resources to researching securities at all, and if people don’t commit resources to researching securities, then how did the prices get right to begin with? ________________________________________ This appears to be difficult to wrap the mind around, but it is a very simple relationship. Mispricings of securities occur randomly as new information develops. If there are people that think they can consistently exploit mispricings, they will spend their resources to exploit them. It only takes a few exploited mispricings to make people believe that they can consistently find more mispricings. When there are enough people trying to exploit mispricings, the prices of securities will tend toward their true value as soon as new information appears. So, markets are efficient because there are a bunch of people out there that don’t think that markets are efficient. As much as this is a paradox, it plays out as an equilibrium in the market. So what would happen if the majority of investors started to buy the market and stopped trying to beat the market? Mispricings would start to develop regularly, and the people that had continued to try and pick stocks 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. Behavioral finance plays a huge role in market efficiency; nobody wants to accept being average by taking what the market gives them when there are hot shot managers that promise to consistently beat their benchmark. 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 remember: whenever one active manager beats the market, another 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 over the long term than to outperform the market one year and underperform the next. People naturally want to beat the market, and they will continue to try no matter what the evidence shows. These people that are set on beating the market are the people that keep the markets efficient; we need the dollars paid to actively managed funds to pay for the constant research that drives the market’s near-perfect pricing mechanism. An efficient market is not a free lunch, I’m just glad our clients aren’t the ones paying for it. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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