A Market Impossibility
Why Efficient Markets
Cannot Exist
If prices already reflect all information, why would anyone pay to acquire information? And if no one acquires information, how do prices reflect it?
The Efficient Market Hypothesis says prices reflect all available information. It is the foundation of modern finance. Index funds, passive investing, the random walk - all built on this idea.
But here is the problem: if markets are truly efficient, there is no profit in research. Every bit of information is already priced in. Why pay analysts? Why read earnings reports?
And if no one researches... how does information get into prices?
Efficient markets are an equilibrium that cannot exist.
This is the Grossman-Stiglitz Paradox, and it won a Nobel Prize.
The Efficiency Assumption
The Efficient Market Hypothesis (EMH) comes in three flavors:
Weak Form
Prices reflect all past trading data. Technical analysis is useless.
Semi-Strong Form
Prices reflect all public information. Fundamental analysis is useless.
Strong Form
Prices reflect ALL information, even private. Insider trading is useless.
The logic is elegant: if a stock is underpriced, smart money will buy it, pushing the price up until it is fairly valued. Mispricings are arbitraged away instantly.
But this logic contains a hidden assumption: someone has to do the work of figuring out the fair value. Someone has to analyze earnings, read 10-Ks and build DCF models.
The paradox: Information discovery is a public good. If you discover a stock is underpriced and buy it, the price rises and everyone benefits - but only you paid the research cost.
Sanford Grossman and Joseph Stiglitz formalized this problem in 1980. Their paper, "On the Impossibility of Informationally Efficient Markets," showed that perfectly efficient markets are logically impossible.
The Paradox Visualized
The paradox creates an endless cycle. Watch it unfold:
This cycle never reaches a stable point. Markets oscillate between states.
The resolution is that markets stabilize at PARTIAL efficiency - just efficient enough to make research barely worthwhile.
Think about it this way: if you are a hedge fund considering whether to hire another analyst, you ask: will the alpha they generate exceed their salary?
In a perfectly efficient market: No. The analyst finds nothing. Do not hire them.
In a highly inefficient market: Definitely yes. There is so much mispricing that even mediocre analysis generates huge returns.
The market settles where these forces balance: efficient enoughthat research is hard, but inefficient enough that it still pays.
Should You Research?
Put yourself in the shoes of a trader. You have two strategies:
Informed Trader
Pay for research, analysis, data feeds. You might find alpha - stocks that are mispriced. But research is expensive.
Uninformed Trader
Just trade on public information. No research costs. But you are competing against those who know more.
Adjust the market efficiency and research cost below to see when each strategy wins:
Informed Trader
Uninformed Trader
Research is profitable! Be an informed trader.
Moderate efficiency - research might pay if costs are low.
Notice the key insight: at high efficiency, research does not pay. You spend money to find... nothing. The market already knows everything.
But at low efficiency, everyone should research. There is so much alpha lying around that even expensive research is worth it.
Neither extreme is stable. The system always drifts toward the middle.
Finding Equilibrium
The equilibrium is where the returns from research exactly equal the cost. Not higher (then more would research), not lower (then fewer would).
At equilibrium, 55% of traders do research.
Moderate costs = balanced market with some inefficiency
This graph shows the core insight: research returns decrease as more traders research. The green curve slopes down because when many traders hunt for alpha, mispricings get corrected quickly, leaving less for everyone.
The equilibrium (orange dot) is where the curve crosses the cost line. Try moving the cost up and down—watch the equilibrium shift.
Key implication: Making research cheaper (better tools, AI, etc.) increases the equilibrium number of researchers, which makes markets MORE efficient. But never perfectly efficient - there is always a gap.
Price Discovery in Action
Here is the mechanism: informed traders push prices toward true values. The more informed traders, the faster prices converge.
But if everyone is uninformed, prices wander randomly - never finding the truth.
True Value
$100
Current Price
$50.00
Price Error
$50.00
Moderate informed trading = reasonable price discovery. This is the equilibrium zone.
Watch the simulation at different informed trader levels:
- 0% informed: Price drifts randomly, never finds the true value
- 30% informed: Slow convergence with lots of noise
- 70%+ informed: Fast, accurate price discovery
This is the paradox in action. We need informed traders for prices to mean anything. But informed traders only exist if the market is inefficient enough to reward them.
Why This Matters
The Grossman-Stiglitz paradox is not just academic. It explains phenomena we see every day:
Why Hedge Funds Charge 2-and-20
Active management is expensive. The fees compensate for the cost of making markets efficient. Without high fees, no one would do the research that makes passive investing work.
Why Market Anomalies Persist
Value premium, momentum, small-cap effects - these persist because exploiting them is costly enough that some inefficiency remains. They are the payment for keeping markets roughly efficient.
Why EMH Is Useful But Not Literal
Markets are efficient enough that beating them is hard, but not so efficient that no one tries. The EMH is a useful approximation, not a physical law.
Why Index Funds Cannot Replace Active Managers
If everyone indexed, prices would stop reflecting information. Some active management is essential for price discovery - index investors free-ride on their work.
The paradox reveals a fundamental truth about markets:
Efficiency is not a state but a process. Markets are efficient because people try to exploit inefficiencies, not despite it. The profit motive that drives research is what creates the efficiency that makes research seem pointless.
Joseph Stiglitz won the 2001 Nobel Prize in Economics partly for this work. The citation specifically mentioned "markets with asymmetric information" - the exact problem the paradox illuminates.
Perfect efficiency is impossible. Partial efficiency is inevitable.
That is the Grossman-Stiglitz equilibrium.
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Reference: Grossman & Stiglitz (1980)