Investors do not like risk and they must be compensated for taking on risk—the larger the risk, the more the compensation. An important question about financial markets, which has implication for the different strategies that investors can pursue, is: Can investors earn a return on financial assets beyond that necessary to compensate them for the risk? Economists refer to this excess compensation as an abnormal return. Whether this can be done in a particular financial market is an empirical question. If a strategy is identified that can generate abnormal returns, the attributes that lead one to implement such a strategy is referred to as a market anomaly.
This issue of how efficiently a financial market prices the assets traded in that market is referred to as market efficiency. An efficient market is defined as a financial market where asset prices rapidly reflect all available information. This means that all available information is already impounded in a asset’s price, so investors should expect to earn a return necessary to compensate them for their opportunity cost, anticipated inflation, and risk. That would seem to preclude abnormal returns. But according to Fama (1970), there are the following three levels of efficiency:

• Weak form efficient
  
• Semistrong form efficient
  
• Strong form efficient

In the weak form of market efficiency, current asset prices reflect all past prices and price movements. In other words, all worthwhile information about previous prices of the stock has been used to determine today’s price; the investor cannot use that same information to predict tomorrow’s price and still earn abnormal profits.4 Empirical evidence from the U.S. stock market suggests that in this market there is weak-form efficient. In other words, you cannot outperform (“beat”) the market by using information on past stock prices.
In the semistrong form of market efficiency, the current asset prices reflect all publicly available information. The implication is that if investors employ investment strategies based on the use of publicly available information, they cannot earn abnormal profits. This does not mean that prices change instantaneously to reflect new information, but rather that information is impounded rapidly into asset prices. Empirical evidence supports the idea that U.S. stock market is for the most part semistrong form efficient. This, in turn, implies that careful analysis of companies that issue stocks cannot consistently produce abnormal returns.
In the strong form of market efficiency, asset prices reflect all public and private information. In other words, the market (which includes all investors) knows everything about all financial assets, including information that has not been released to the public. The strong form implies that you cannot make abnormal returns from trading on inside information (discussed later), where inside information is information that is not yet public.5 In the U.S. stock market, this form of market efficiency is not supported by the empirical studies. In fact, we know from recent events that the opposite is true; gains are available from inside information. Thus, the U.S. stock market, the empirical evidence suggests, is essentially semistrong efficient but not in the strong form.
We have discussed the implications for investors of the different forms of market efficiency. The implications for market efficiency for issuers is that if the financial markets in which they issue securities are semistrong efficient, issuers should expect investors to pay a price for those shares that reflects their value. This also means that if new information about the issuer is revealed to the public (for example, concerning a new product), the price of the security should change to reflect that new information.