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 even insider information cannot give an investor an advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be realized regardless of the amount of research or information investors can access.
Understanding 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 the opposite of weak form efficiency, which states that past events have no effect on current securities prices and price movements.
Origins of the Strong Form Efficiency Concept
The concept of strong form efficiency was pioneered by Princeton economics professor Burton G. Malkiel in his book published in 1973 entitled "A Random Walk Down Wall Street." The book championed two forms of the random walk theory. The semi-strong form explains that public information will not help an investor to select undervalued securities because it is reflected in the current market prices. Therefore, it is impossible to earn long-term abnormal returns. The strong form states that no information, public or inside information, will benefit an investor because even inside information is reflected in the current stock price.
Example of Strong Form Efficiency
Most examples of strong form efficiency involve 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 inside information will not help an investor earn high returns in the market.
For example, a 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, the CTO will profit and, if the stock prices increases, he will lose money. However, when the product feature is released to the public, the stock price is unaffected and does not decline even though customers are disappointed with the product. This market is 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.