The Grossman-Stiglitz Paradox

Well I have just finished my trip down to Santa Monica to learn more about DFA (Dimensional Fund Advisors), and I have lots to share. While their public website is okay, it really doesn’t give you a sense of what DFA is (in my opinion). As such, I’ll be writing about 30 posts or so on DFA over the next few months (some of the posts will be going down tangents), because there is something very special about this outfit that I don’t think is captured in their website.

One of the points raised by Kenneth French (a member of the Board of Directors and the ‘French’ part of the Fama-French 3 Factor Model) was the Grossman-Stiglitz Paradox.

The Grossman-Stiglitz Paradox

If we make the following two assumptions:

1. Prices are right (i.e. the market is efficient)
2. Researching securities costs time and energy

Then:

1. If prices ARE right, why would you spend time and energy researching securities?
2. If prices ARE right, and therefore you DON’T spend time and energy researching securities, then how did prices get right in the first place?

It is an interesting paradox, and actually is a knock on the strong form of efficient market hypothesis. I suppose that Dr. French’s discussion of this paradox in itself is a bit paradoxical on the surface since Fama and French believe in passive investing through DFA. However, Dr. French indicated that one possible solution is that there have to be only enough mispricings to tempt people into expending this time and energy. They believe this to be a futile endeavour – the reasons for which will be covered in future posts.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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  • Richard

    You research because once in a while prices aren’t right, and being able to detect that gives you an opportunity to make money. Multiply by a few million people and prices usually follow true value pretty closely. More precisely, prices are always slightly wrong but the error may be a small fraction of the commission it would cost you to trade.

    Maybe it’s a big waste of time for most people – but that means this paradox is based on the idea that everyone invests in stocks only with logic and reason :D

  • Preet

    @Richard – an excellent point. If I had a nickel for every time I’ve heard someone buying certain stock without even knowing how to read a balance sheet, let alone taking the time to truly research a company before buying it… :)

  • Joe Dolan

    Preet, great website. Having trouble subscribing to your daily e-mail update service.

    didn’t know where else to post this. Discovered site after reading globe article.

    All the best–Joe

  • Preet

    @ Joe – thanks for the note. I’ll sign you up manually – but note, that you will receive a confirmation email from feedburner (the provider of service that allows me to send out email updates automatically). The email will come from “confirmations@emailenfuego.com” – it might be going to your junk mail folder – so check there if you don’t see it (it should be there now).

    In that email, you will need to click on the activation link provided, once you do that you should start receiving email updates. (you should expect about 5 per week). To unsubscribe, there will be a link at the bottom of each email labelled “unsubscribe”.

    Thanks Joe – hope you enjoy the future posts!

  • Joe Dolan

    Preet, why don’t they offer DFA funds to diyers? DFA funds don’t seem that special to me. I think DFA is missing out on a lot of retail business by their restrictive rules that they have in place?

    Just my opinion. First day on this site and I love it already—lol.

  • Preet

    @ Joe – thanks for the compliment – cheque is in the mail! :)

    As you will probably notice shortly, I am just about to write extensively on DFA. You are correct that on the surface they just appear to be similar to index ETFs, but there is so much more to it. I like to think of myself as one of the more analytical advisors out there and it took me weeks and weeks of prep and much, much reading after the conference to fully appreciate what DFA is and does – because it is very unique.

    You are correct that DFA could probably get a lot more business if they offered their funds to DIY investors through discount brokerages, but they don’t want anyone investing in their funds if they don’t understand them and they absolutely abhor “hot money” – i.e. investors who throw money at a perceptually hot product. The long term returns for their oldest funds have beaten their benchmarks after fees so this would be appealing, but it’s possible for the funds to underperform the traditional indices – and that might cause those new investors to jump ship – this really hurts the long term investors since it forces the managers to liquidate positions to pay for redemptions which could not only have market impact (concept will be discussed later) and create unfavourable tax consequences as well (increased turnover).

    I’ll do my best to convey my thoughts – but be warned it will take many many posts – easily 30. This will be a big project…

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