Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Weak Form Efficiency

What it is:

The random walk theory states that market and securities prices are random and not influenced by past events. The idea is also referred to as weak form efficiency or the weak form efficient-market hypothesis.

Princeton economics professor Burton G. Malkiel coined the term in his 1973 book A Random Walk Down Wall Street.

How it works (Example):

The central idea behind weak-form efficiency is that the randomness of stock prices renders attempts to find price patterns or take advantage of new information futile. In particular, the theory claims that day-to-day stock prices are independent of each other, meaning that price "momentum" does not generally exist and past earnings growth does not predict future growth. Malkiel argues that people often believe events are correlated if the events come in "clusters and streaks," even though "streaks" occur in random data such as coin tosses.

In turn, the theory also considers technical analysis undependable because stock prices already reflect all information. Malkiel also finds fundamental analysis flawed because analysts often collect bad or useless information and then poorly or incorrectly interpret that information when predicting stock values. Factors outside of a company or its industry may affect a stock price, rendering further the fundamental analysis irrelevant.

Why it Matters:

The random walk theory essentially proclaims that it is impossible to consistently outperform the market, particularly in the short term, because it is impossible to predict stock prices. This may be controversial, but by far the most controversial aspect of the theory is its claim that analysts and professional advisors add little or no value to portfolios, especially mutual fund managers (with the notable exception of those managing funds that take on greater risks), and that professionally managed portfolios do not consistently outperform randomly selected portfolios with equivalent risk characteristics. As Malkiel put it, "Investment advisory services, earnings predictions, and complicated chart patterns are useless....Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."