What is the Random Walk Theory?

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 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 Does the Random Walk Theory Work?

The central idea behind the random walk theory 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 momentum does not generally exist and calculations of past earnings growth does not predict future growth. Malkiel states 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.

The random walk theory also states that all methods of predicting stock prices are futile in the long run. Malkiel calls the notion of intrinsic value undependable because it relies on subjective estimates of future earnings using factors like expected growth rates, expected dividend payouts, estimated risk, and interest rates.

The random walk theory also considers technical analysis undependable because, according to Malkiel, chartists buy only after price trends are established and sell only after price trends are broken; essentially, the chartists buy or sell too late and miss the boat. According to the theory, this happens because stock prices already reflect the information by the time the analyst moves on the stock. Malkiel also notes that the widespread use of technical analysis reduces the advantages of the approach.

Further, Malkiel 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.

There are two forms of the random walk theory. In both forms, the rapid incorporation of information is disadvantageous for investors and analysts. The semi-strong form states that public information will not help an investor or analyst select undervalued securities because the market has already incorporated the information into the stock price. The strong form states that no information, public or private, will benefit an investor or analyst because even inside information is reflected in the current stock price.

Malkiel acknowledges some statistical anomalies pointing to some exceptions to the random walk theory:

1. Prices of small, less liquid stocks seem to have some serial price correlation in the short-term because they do not incorporate information into their prices as quickly.

2. Contrarian strategies tend to outperform other strategies because reversals are often based on economic facts rather than investor psychology.

3. There are seasonal trends in the stock market, especially at the beginning of the year and the end of the week.

4. Stocks with low P/E ratios tend to outperform those with high P/Es, although the tendency is volatile over time.

5. High-dividend stocks tend to provide higher returns over time because during down markets the high dividend yields often create demand for these stocks and thus increases the price.

Why Does the Random Walk Theory Matter?

The random walk theory 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. 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.'

Malkiel and the random walk theory provide considerable support to the intimidated individual investor, but Malkiel in particular encourages investors to understand the theories and investment methods that the random walk theory challenges. Malkiel therefore advocates a buy-and-hold investment strategy as the best way to maximize returns.