Now that we have a little more precise notion of what it means to beat the market, we can be a little more precise about market efficiency. A market is efficient with respect to some particular information if that information is not useful in earning a positive excess return. Notice the emphasis we place on “with respect to some particular information.”
For example, it seems unlikely that knowledge of Shaquille O’Neal’s free-throw shooting percentage would be of any use in beating the market. If so, we would say that the market is efficient with respect to the information in O’Neal’s free throw percentage. On the other hand, if you have prior knowledge concerning impending takeover offers, you could most definitely use that information to earn a positive excess return. Thus, the market is not efficient with regard to this information. We hasten to add that such information is probably “insider” information and insider trading is illegal (in the United States, at least). Using it might well earn you a jail cell and a stiff financial penalty.
Thus, the question of whether or not a market is efficient is meaningful only relative to some type of information. Put differently, if you are asked whether a particular market is efficient, you should always reply, “With respect to what information?” Three general types of information are particularly interesting in this context, and it is traditional to define three forms of market efficiency: (1) weak, (2) semistrong, and (3) strong.