Strong Form Efficiency

What Is Strong Form Efficiency?

Strong Form Efficiency is a pricing efficiency that assumes that a security's price reflects all information irrespective of whether they are publicly available or not. It states that no investor can gain excess returns. Legal barriers to private information publication, like insider trading laws, hinder strong-form efficiency.

Security prices properly represent both public and private information in this form of an efficient market. Market prices already reflect insider knowledge, making it impossible for insiders to make abnormal profits through trading on them. However, because using nonpublic information might result in abnormal profits, researchers find that markets typically need to be strong form efficient.

• In strong form efficiency, share prices accurately incorporate all private information, challenging the idea of beating the market with insider knowledge.
• It follows that no investor can outperform the market and generate abnormally large returns over extended periods. Since full access to investors' confidential financial data and transactions would be necessary, industry experts are unable to substantiate this claim.
• This form of efficiency is different from the weak form of efficiency, as in this type of market, the share price represents all the past data, and this data cannot influence future prices.

Strong Form Efficiency Explained

Strong form efficiency describes a market in which all private (insider) knowledge is fully and fairly reflected in share prices. This is in addition to all the information that is previously and publicly available. It challenges the idea that investors can reliably beat the market by taking advantage of private information. It is impossible to make abnormal gains in such a market by examining any information. Despite being illegal, traders in advanced financial markets can still profit from insider information, challenging the notion of strong-form efficiency. The financial theory sees developed capital markets as efficient, with forecasts on company dynamics often accurate.

Research indicates that capital markets are highly efficient; no right or wrong time exists to issue new shares. It considers factors such as needed shares for financing, impact on earnings per share, control dilution, gearing, and financial risk. Businesses must not falsify information for capital markets; instead, let an efficient market truthfully represent all facts.

Examples

Let us look at a few examples to understand the concept better:

Example #1

In a hypothetical scenario, suppose XYZ Ltd.'s CEO has insider knowledge of a forthcoming merger that will greatly affect the stock price. He decides to let out the information in exchange for money. If the market is strong-form efficient, the stock price would already reflect this information, making it impossible for the CEO or any other market participant to profit from trading on this insider knowledge. And since XYZ belongs to a strong form market, he could not make extravagant profits.

Example #2

The paper looked into more than 340 stocks from the Prowess database from 2003–2007 to gain insights into the markets of developing countries. It found that the Indian market has a substantial form. They discovered that even mutual fund managers with access to more advanced analytical tools, superior data, and insider knowledge were unable to outperform randomly chosen index portfolios. Investors can generate returns on par with professionally managed funds by assembling their portfolios without professional assistance.

Effects

Effects of strong form efficient markets are given as follows:

#1 - Limited Potential For Abnormal Returns

In a strongly efficient market, all information, including private or insider data, is immediately reflected in security prices. Consequently, investors need more opportunities to consistently achieve abnormal returns by trading on such information.

#2 - Diminished Efficacy Of Active Trading Approaches

Strong efficiency poses challenges to active trading strategies that depend on exploiting private or insider information. Investors may need help consistently outperforming the market through activities like stock selection or market timing.

#3 - Enhancement Of Market Fairness And Integrity

Strong efficiency promotes market integrity and fairness by ensuring equal access to information for all market participants. It mitigates the likelihood of insider trading and unfair advantages stemming from private data.

#4 - Emphasis On Alternative Factors

In an efficient market, investors consider risk factors, asset allocation, and cost optimization to generate returns. Passive investment options like index funds can be focused on.

Strong Form Efficiency vs Weak Form Efficiency 

The differences between both concepts are given below:

Points	Strong Form Efficiency	Weak Form Efficiency
Definition	This efficiency asserts that the price of a stock incorporates all the private and public information available.	Weak form efficiency argues that the current stock price reflects all accessible market data and historical price movements do not influence future prices.
Essence	This suggests that no investor can consistently outperform the market and achieve abnormal returns over extended periods.	Furthermore, investors cannot analyze historical data or patterns to predict future stock performance.
Implication	No investor group would consistently earn returns above the market average, and additionally, transaction costs remain minimal.	It indicates that past returns should not predict future returns, yet above-average returns can still be attained in a weak, efficient market.

Frequently Asked Questions (FAQs)

Recommended Articles

This article has been a guide to what is Strong Form Efficiency. Here, we explain its examples, effects, & comparison with weak form efficiency. You may also find some useful articles here –

• Weak Form Efficiency
• Information Leakage
• Market Efficiency