Random Walk Theory

Reviewed by Sujaini | Updated on Aug 27, 2020

What Is the Random Walk Theory?

The theory of random walks implies that stock price shifts have the same distribution and are distinct from each other. It is believed that the past change or pattern of a stock price or economy cannot be used to forecast the future movement.

In other words, random walk theory states that stocks are taking a random and unpredictable path, which, in the long run, makes all methods of predicting stock prices futile.

Random Walk Theory Explained

Random walk theory assumes the market cannot be outperformed without taking on additional risk. It finds technical analyses to be undependable because chartists only buy or sell a security after a pattern has formed.

Similarly, due to the often poor quality of the collected information and its potential to be misinterpreted, the theory finds fundamental analysis undependable. The theory's opponents argue that stocks sustain price trends over time. That is, by carefully selecting the entry and exit points for equity investments, it is possible to outperform the market.

Random Walk Theory in Reality

A practical example of random walk theory occurred in 1988. The Wall Street Journal attempted to test Malkiel's theory by establishing the annual Wall Street Journal Dartboard Contest, pitting professional investors for stock-picking dominance against darts. Staff members of the Wall Street Journal had the job of the dart-throwing monkeys.

The Wall Street Journal published the findings after 100 competitions, which revealed that the dart throwers won 39 of the contests and the experts won 61. The analysts have only been able to beat the Dow Jones Industrial Average (DJIA) in 51 competitions.

Malkiel commented that the experts' picks benefited from the publicity jump in the price of a stock that tends to occur when stock experts make a recommendation.