Methodology

Stocks

Module 3

Weak Form Efficiency

The weak version of market efficiency assumes that past information does not affect current stock prices, therefore it is impossible to use the past to predict what is going to happen in the future.

Investors that subscribe to weak market efficiency, believe that looking at the stock chart is a waste of time and that it is impossible to identify patterns in past stock data to predict future patterns.

Weak market efficiency is often referred to as random walk theory, which as the name suggests, assumes that the stock market is completely random.

Investors that hold a random walk perspective typically believe that is not possible to outperform the overall stock market. Instead of owning individual stocks in a portfolio, they believe that index funds are more suitable.

Weak form efficiency in practice

As the stock market is completely random, according to the weak form efficient perspective, it is not possible to make money from the stock market by identifying patterns or by using information.

So, strategies like day trading or growth investing are considered to be a complete waste of time. As the market is random, it is not possible to identify patterns that can help an investor to make a profit. 

Although the stock market may seem to be random in the short term, in reality, there is plenty of evidence that shows that information does have a significant impact on stock prices. For example, during the financial crisis of 2008, global stock markets sunk in response to events. 

Therefore, it is clear that information does have an impact on stock prices, especially over time, which is why weak form efficiency is not widely regarded as being accurate.

Strong Form Efficiency

Strong form market efficiency believes that all relevant information is fully accounted for in stock prices, regardless of whether the information is publicly available or not.

This means that the value of the stock mirrors the true value of each company with full efficiency. This implies that there is no advantage to be gained through research as all information is already priced in.

Strong market efficiency suggests that even illegal insider information isn’t useful in terms of gaining an advantage in the market because that information is already accounted for.

Those that believe in strong form market efficiency suggest that the best approach when investing in stocks is to simply buy and hold stocks to get the best return.

Strong Form Efficiency in practice

In practice, there could be cases where strong form efficiency is observed.

For example, there is a phenomenon called the neglected stock effect, which occurs when the stock price of a company doesn’t move in the direction that is expected, due to a lack of interest.

However, this does not mean that the stock price has necessarily priced in the insider information, but it is more so that the stock is not very popular.

In reality, the majority of investors do not have access to insider information as it is illegal. Developed stock markets have systems in place that detect when insider information has been used, leading to prosecution.

With millions of people buying and selling stocks on a daily basis, it is unlikely that stocks have already priced in insider information. For that reason, strong form efficiency is not widely accepted as a justified explanation of how the stock market operates.

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