What is the Random Walk Theory?
The Random Walk Theory assumes price movements in the stock market are not predictable since they are determined by unexpected events with no correlation to the past.
Random Walk Theory – Hypothesis Assumptions
The random walk theory states the prices reflected in the stock market are determined by random events independent of the past, i.e. there is no reliable orderly pattern.
In 1973, economist Burton Malkiel popularized the term in his book, A Random Walk Down Wall Street.
A “random walk” in probability theory refers to random variables impacting processes that are uncorrelated to past events and each other, i.e. there is no pattern to the randomness.
Historical data cannot be relied upon to reliably anticipate the future, which is contrary to the statement that “history repeats itself”.
Proponents of the random walk theory argue that forecasting is essentially pointless because for the models to be correct, they must accurately project random variables uncorrelated with the past.
If there were a pattern of fundamental or technical indicators, then the changes could be forecasted — but the random walk assumption claims otherwise.
Random Walk Theory in Stock Market
The behavior of share price movements in the stock market is due to random, unpredictable events, according to the random walk theory.
The random walk assumption argues that attempts to predict share price movements accurately are futile, contrary to what active managers such as hedge funds claim.
Even if a decision were to be correct (and profitable) — regardless of the amount of fundamental or technical analysis used to support the decision — the positive outcome is more attributable to chance rather than actual skill.
Attempting to “beat the market” requires constantly taking on a substantial amount of “unjustifiable” risk because the outcome is a pure function of chance.