- The Grossman-Stiglitz paradox,
stems from a 1980 paper by Sanford Grossman
and Joseph Stiglitz.
They argued, that markets cannot possibly be perfectly,
informationally efficient, because if they were,
nobody would expend the resources required
to make markets efficient in the first place,
let's dig into what that means.
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I talk a lot about index funds on this channel.
Index funds only work well in an efficient market.
Market efficiency, is a term that was coined by Eugene Fama
in 1965, and defined formally again by Fama in 1970.
He defined it as, a market in which prices
always fully reflect available information.
If prices always fully reflect available information,
then we would expect market prices to change
as soon as new information develops.
New information could range from a company announcing,
a new product line,
to changes in the broad economic outlook of a given country.
If markets are efficient,
stock prices should adjust to account
for these changing conditions very quickly.
If it is in fact the case that markets are efficient,
then we would expect it to be incredibly difficult
for traditional active investors to earn a return
in excess of the market, by exploiting mispriced securities.
In a perfectly efficient market,
undervalued and overvalued stocks don't exist.
There's no mispricing that can be exploited
to achieve above average returns.
Under these conditions, index funds make a ton of sense.
But, coming back to the paradox,
if everyone starts to index,
then prices have no way of adjusting to new information.
To dig into this, let's think about how information
gets into prices.
To explain how stocks are priced,
I would like to introduce you to Richard Coffin,
also known as, The Plain Bagel on YouTube.
If you haven't checked out The Plain Bagel,
it is an excellent source of entertaining,
educational material on financial concepts,
investing and answers to frequently asked questions.
Here's Richard, and I'll be back to finish off the video.
- Public stock prices are entirely determined
by the transactions carried out by investors.
There is no authority that fixes the price or tells people
what to buy and sell a stock for.
Instead, the prices we see are determined
by the transactions of individual buyers and sellers
on the market.
Passive investors largely believe that,
when there are many investors present,
markets will operate efficiently.
That is that these transaction based stock prices
will reflect the stock's intrinsic value,
or what they are actually worth.
Active investors on the other hand,
often believe that markets are inefficient
to at least some degree,
whether it be because of the irrational tendencies
of investors and their behavioral biases, market anomalies
or the influence of institutional money flows
on market prices, active investors believe that stock prices
frequently trade higher or lower than their actual worth.
But, how do active investors know,
when a stock is expensive or cheap?
Well, the truth is that, they don't,
but they can estimate what they believe,
to be the intrinsic value of a stock
and then compare the estimate to the current stock price.
How investors get this estimated value can vary,
but one popular method is through the use
of the discounted cash flow model.
There are a few key steps involved
with the discounted cash flow model,
the first of which is to forecast
the company's future profitability or cash flows.
This is where active investors,
carry out fundamental analysis
and how they apply the information they have,
about a company.
For example,
perhaps they've looked at a company's management,
their product quality and their strategic growth plan
for the near term, and see that the company,
appears to be a solid business,
so they may forecast strong growth for the next five years.
Analysts may also make adjustments for external factors
outside the company's control.
Perhaps they believe that a slowing economy
will dampen sales in 2020,
but that the cycle will recover come 2022.
Or maybe because of higher input costs,
the analysts expect margins to see compression,
for the next three years.
Once an analyst has forecasted a company's profitability,
they apply a discount, hence the discounted cash flow.
The level of the discount is largely subjective,
but it will be higher for high risk companies
and lower for more mature firms.
This discount also helps take into account
the variability of estimates,
it's not likely that an analyst's number will be on the dot.
But, if there's a chance that the forecast
will be completely off, then analysts will increase
their discount, on the future cash flows,
thereby pricing in this added risk.
Finally, the analyst sums up the discounted cash flows
to get to the value of the company,
makes necessary adjustments for debt
and then divides this amount
by the number of shares outstanding,
to get to a stock's estimated value.
They can then compare this value
to the stock's current price,
to determine whether the stock is over or undervalued
and to what degree.
So, active investors will often have some value
that they believe to be the true intrinsic value
of a stock in mind.
If a stock is trading below this amount,
they may buy the stock, and it is through this process
that stocks trade at least somewhat close
to their intrinsic value.
By buying undervalued stock,
active investors actually apply upward pressure
to the stock price,
which will bring it closer to the price that they believe,
it is actually worth.
This is why when a company releases,
positive or negative news, we see prices react accordingly,
analysts update their models with this added information,
which may boost or lower their estimated price
and lead to a respective buy or sell,
thereby changing the price of the stock.
Without active investors, stock prices likely wouldn't react
to positive or negative news,
even though these could be things that,
inherently alter the value of a stock.
- Now, that we have an understanding of the careful work
and analysis that goes on behind the scenes
to get information into prices,
we can think about the effect of competition
on the stock market as a whole.
In a liquid and competitive market,
such as the public financial market,
the price aggregates dispersed bits of information.
F.A. Hayek, a notable economist pointed out in the 1940s
that there are two types of information.
General information that is widely available
to everyone in the market.
This would be something like an analyst report
or a public press release from a company,
and specific knowledge,
that each individual market participant has,
including their unique views, preferences and needs.
One of the challenges for investors,
is that both types of information can move prices.
Every market participant,
wants to be the first to bring to the market new information
that has not yet been included in the price.
If we think about what we just heard Richard say,
all of those analysts are grinding through numbers
in order to come up with a price
based on their information and insights.
If they get it right, while everyone else has it wrong,
they will earn a profit in excess of the market return,
known as alpha.
The challenge is that no participant
has the full set of information,
because each participant has some specific knowledge
not generally available to others.
The intense competition for profits,
results in market prices,
usually reflecting available information
about the fundamental values and expectations
for each company, due to the hard work of analysts.
But because each market participant
has unique information, no single participant
is able to interact with the market in isolation.
We can now see how markets can be mostly efficient
most of the time, while still allowing market participants
the opportunity, but definitely not the guarantee,
to profit after costs by being the first
to bring new information to market,
if their information is better than their competitors.
This is the equilibrium,
that allows the mostly efficient market to persist.
Whether you want to be part of the race to profit
by uncovering and bringing new information to the market,
or be the passive beneficiary of those doing the work
is largely a personal choice.
- It's an interesting phenomenon,
despite the continual debate between,
active and passive investment management,
the two schools of thought actually need one another.
Passive management relies on active management
to move the prices of stocks close to their intrinsic value.
And, active management relies on passive management
to avoid excessive market volatility
that would come from excessive buying and selling,
perhaps the two can actually exist in harmony.
After all, as highlighted by the Grossman-Stiglitz paradox,
markets can only be efficient for passive investors
if active investors find market inefficiencies.
Thanks for watching,
and thank you Ben for the collaboration opportunity.
- Thanks for watching, my name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
I will be talking about a new Common Sense Investing topic
every two weeks, so subscribe, click the bell for updates.
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