Strong Form Efficiency

What is 'Strong Form Efficiency'

Strong form efficiency is the strongest version of market efficiency and states that all information in a market, whether public or private, is accounted for in a stock's price. Practitioners of strong form efficiency believe that not even insider information can give an investor an advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to.

BREAKING DOWN 'Strong Form Efficiency'

Strong form efficiency is a component of the efficient market hypothesis and is considered part of the random walk theory. Strong form efficiency states that securities prices, and therefore the overall market, are not random and are influenced by past events. This efficiency is at the opposite end of weak form efficiency, which states that past events have no effect on current securities prices and price movements.

The idea behind strong form efficiency was pioneered by Princeton economics professor Burton G. Malkiel in his 1973 book "A Random Walk Down Wall Street." The book championed two forms of the random walk theory. The form that explains strong form efficiency states that it is impossible to consistently outperform the market due to the fact that all information, both public and proprietary, is reflected in current market prices, and it is therefore impossible to earn long-term abnormal returns.

Example of Strong Form Efficiency

Most examples of strong form efficiency include some sort of insider information. This is because strong form efficiency is the only part of the efficient market hypothesis that takes into account proprietary information. However, the efficiency theory states that contrary to popular belief, harboring some sort of inside information won't help an investor earn high returns in the market.

Let's say, for example, that the CTO of a public technology company believes that his company will begin to lose customers and revenues. After the internal rollout of a new product feature to beta testers, the CTO's fears are confirmed and he knows that the official rollout will be a flop. This would be considered insider information.

The CTO decides to take up a short position on his own company, effectively betting against the stock price movement. If the stock price declines, he is poised to profit, and vice versa. However, much to the CTO's chagrin, when the product feature is released to the public, the stock price is unaffected and does not decline, even though customers are not happy. The market would be considered to be strong form efficient because even the insider information of the product flop was already priced into the stock. The CTO would lose money in this situation.

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