GROSSman Stiglitz paradox

Sorry if this comes across as an attempt to impress you with Fancy words and complex language. That was NOT the intention of this blog.

I came across this paradox while reading a research paper and decided to pen down my interpretation.

As the name gives it away, the paradox was introduced by two gentlemen (Sandford Grossman and Joseph Stiglitz) in a joint publication in American Economic Review in 1980[1] which argues

perfectly informationally efficient markets are an impossibility since, if prices perfectly reflected available information, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse

Matt levine has written a great article explaining the paradox here

Lets break it down in the laymen terms, In a nutshell what this paradox is saying is that

If the active fund managers are Good. They will sniff opportunities (mispriced bets) and therefore arbitrage the gap away making index funds more robust. And now since index funds cost is far lower than them, by the virtue of being good at their job, they will NOT be able to beat the index.

Warren Buffet in one of his annual letter said it the best, he said something on the lines of , “Markets are efficient most of the time but it is ridiculous to take that argument and conclude that it is efficient ALL the TIME.

Similarly, on the opposite side, It is incentive that drives an active fund manager (specially of a large cap) to proclaim and dream that he can beat the index fund whereas writing is on the wall (is 10 years long enough) that after accounting for fees, they (cumulatively) under perform it by a BIG margin.

Conclusion: The game gets increasingly difficult as the participants become smarter. Jury is In already on LARGE CAPS. Lets see how long before mid-smallcap alpha vanishes!!!

Comments are welcome.

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