:Strong Form Efficiency: Economic Theory Explained

What Is Strong Form Efficiency?

Strong form efficiency is the most stringent version of the efficient market hypothesis (EMH) investment theory, stating 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 have access to.

Understanding Strong Form Efficiency

Strong form efficiency is a component of the EMH and is considered part of the random walk theory. It states that the price of securities and, therefore the overall market, are not random and are influenced by past events.

Strong form efficiency is one of the three different degrees of the EMH, the others being weak and semi-strong efficiency. Each one is based on the same basic theory but varies slightly in terms of stringency.

Strong Form Efficiency vs. Weak Form Efficiency and Semi-Strong Form Efficiency

The weak form efficiency theory, the most lenient of the bunch, argues that stock prices reflect all current information but also concedes that anomalies may be found by researching companies' financial statements thoroughly.

The semi-strong form efficiency theory goes one step further, promoting the idea that all information in the public domain is used in the calculation of a stock's current price. That means it is impossible for investors to identify undervalued securities and generate higher returns in the market by utilizing either technical or fundamental analysis.

Those who subscribe to this version of the EMH believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market. The strong form efficiency theory rejects this notion, stating that no information, public or inside information, will benefit an investor because even inside information is reflected in the current stock price.

History of Strong Form Efficiency

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." 

Malkiel described earnings estimates, technical analysis, and investment advisory services as “useless.” He said the best way to maximize returns is by following a buy-and-hold strategy, adding that portfolios constructed by experts should fare no better than a basket of stocks put together by a blindfolded monkey.

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 EMH that takes into account proprietary information. The theory states that contrary to popular belief, harboring inside information will not help an investor earn high returns in the market.

Here’s an example of how strong form efficiency could play out in real life. A chief technology officer (CTO) of a public technology company believes that his firm 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 in 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.