The Indexing Paradox -- Be Thankful for Irrational Investors
This paper introduces the indexing paradox, which states that it if all investors are rational with rational expectations and have a common risk-averse investment performance measure, then no investor can expect to do better than the market. If the cost of indexing is less than the cost of active investing, then all investors would index, which would result with no mechanism to price the possible investments. This paradox relies merely on understanding averages. It does not rely on markets being “informationally efficient,” as demonstrated in a model where different investors have differing degrees of informational advantages and disadvantages.
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- Grossman, Sanford J & Stiglitz, Joseph E, 1980.
"On the Impossibility of Informationally Efficient Markets,"
American Economic Review,
American Economic Association, vol. 70(3), pages 393-408, June.
- Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
- Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
- Ross M. Miller, 2005. "Measuring the True Cost of Active Management by Mutual Funds," Finance 0506010, EconWPA, revised 08 Jul 2005.
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