Depending upon the level of information considered there are three forms of market efficiencies. They are:
1.1. Weak Form
This is also known as a random walk. This theory says that the current prices fully reflect all the historical information, hence, any attempt to predict the prices based on the historical price or information is totally futile as future price changes are independent of past price changes.
According to this rule, abnormal risk-adjusted returns cannot be earned using trading rules and technical analysis, which make an investment decision based on historical data.
It is not surprising to note that the weak form holds good in any market since even the critics of the efficient market hypothesis will admit that prices adjust to information albeit with a lag.
1.2. Semi-Strong Form
According to this form, current stock prices reflect all publically available information such as earnings, stock, and cash dividends, splits, mergers and takeovers, interest rate changes, etc. It also says that prices adjust to such information ‘quickly and accurately’ so abnormal/superior profits on a consistent basis cannot be earned.
Therefore, according to this rule, investors cannot earn abnormal risk-adjusted returns, if their investment decisions are based on important material information after it has been made public.
1.3. Strong Form
According to the strong form, prices of securities fully reflect all available information – both public and private. That is, if this form is true, prices reflect the information that is available to only selected groups – like the management, financers, and the stock exchange officials.
There are two versions of strong form- the near strong form and the super-strong form. As per the near strong form, conclusions and opinions drawn by the analysts are also reflected in the prices. The super-strong form is more extreme and states that the confidential information available to a selected few is also of no use in obtaining the abnormal returns, as the prices contain the adjustment for that information as well. As can be expected, the super-strong form has been rejected by many, while near strong form found some support.
Thus, the biggest implication of the efficient market hypothesis is that since all the information gets reflected in the prices, sooner or later, the chances of earning the abnormal risk-adjusted returns are minimal. Therefore, active managers are a waste of money for the investors.
The degree of information as reflected in different degrees of efficient markets can be summarized as follows:
Form of Market Efficiency |
Market Prices Reflects |
||
Past Market Data |
Public Information |
Private Information |
|
Weak- Form |
* |
|
|
Semi-Strong Form |
* |
* |
|
Strong Form |
* |
* |
* |