The very existence of efficient markets depends on the tireless efforts of active investors who believe they are not.
The Impossibility of Perfection
In the world of modern finance, the concept of market efficiency is often treated as a binary state: either prices reflect all available information, or they do not. This idea, formalized by Eugene Fama in the 1970s, suggests that in an efficient market, undervalued and overvalued stocks simply do not exist. If a company announces a breakthrough product or a country faces a shift in economic outlook, the stock price should adjust almost instantaneously. For the passive investor, this is a comforting reality that justifies the use of low-cost index funds. If you cannot beat the market by exploiting mispricings, the logical move is to simply own the market.
However, this logic hits a conceptual wall known as the Grossman-Stiglitz paradox. In their seminal 1980 paper, Sanford Grossman and Joseph Stiglitz argued that markets cannot possibly be perfectly informationally efficient. Their reasoning was deceptively simple: if prices always perfectly reflected all information, there would be no profit to be made from gathering that information. If there is no profit to be made, no one would expend the resources—the time, the data, and the intellectual labor—required to analyze companies. And if no one is doing the work to analyze companies, the market cannot stay efficient. The paradox reveals that efficiency requires a degree of inefficiency to function.
How Information Enters the Price
To understand why this paradox matters, we must look at the mechanics of price discovery. Public stock prices are not set by a central authority; they are the result of millions of individual transactions. For a price to move in response to news, an investor must first interpret that news and then act on it. This is the domain of the active investor, who operates on the belief that markets are at least somewhat inefficient due to behavioral biases, institutional flows, or simple human error.
Active analysts use fundamental analysis to estimate a stock's "intrinsic value." A common tool for this is the Discounted Cash Flow (DCF) model, where an analyst forecasts a company’s future profitability and then applies a discount rate based on the riskiness of those cash flows. When an analyst determines that a stock is trading below its intrinsic value, they buy. This buying activity applies upward pressure on the price, moving it closer to its "fair" value. Without this constant cycle of analysis and transaction, stock prices would remain stagnant even as the underlying reality of the business changed.
The Competition for Alpha
The market acts as a giant processor of two distinct types of information, a concept famously explored by economist F.A. Hayek. There is general information, such as press releases and public filings, which is available to everyone. Then there is specific knowledge: the unique insights, preferences, and interpretations held by individual participants. The competition in the market is essentially a race to be the first to bring this specific knowledge to the surface. When an analyst identifies a nuance that the rest of the market has missed, they have the opportunity to earn "alpha," or returns in excess of the market average.
This intense competition is what keeps the market "mostly" efficient. Because every participant is grinding through numbers to find an edge, prices usually reflect a broad aggregate of expectations. However, because no single person has a monopoly on information, no one can interact with the market in total isolation. The price we see on our screens is the equilibrium point where the collective insights of all active participants meet. It is a fragile balance maintained by the hope of profit.
A Symbiotic Equilibrium
The tension between active and passive management is often framed as a battle, but the Grossman-Stiglitz paradox suggests they are actually in a symbiotic relationship. Passive management relies entirely on active managers to do the heavy lifting of price discovery. If everyone switched to indexing, the link between a company’s performance and its stock price would eventually sever, as there would be no one left to sell the losers and buy the winners.
Conversely, active management benefits from a healthy base of passive investors to provide liquidity and dampen the volatility that would arise if every single participant were constantly churning their portfolio based on the latest headline. The market settles into an equilibrium where it is efficient enough that most people are better off indexing, but inefficient enough that a small group of skilled, hardworking professionals can still justify the cost of their research. Whether you choose to join the race for alpha or simply benefit from the work of those who do, both roles are essential to the ecosystem of modern finance.