Loading the player...

What is the 'Random Walk Theory'

The random walk theory suggests that stock price changes have the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement. In short, this is the idea that stocks take a random and unpredictable path.

BREAKING DOWN 'Random Walk Theory'

A follower of the random walk theory believes it's impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain price trends over time – in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.

Efficient Markets Are Random

This theory raised a lot of eyebrows in 1973 when author Burton Malkiel wrote "A Random Walk Down Wall Street." The book popularized the efficient market hypothesis, an earlier theory posed by University of Chicago professor William Sharp. The efficient market hypothesis says that stock prices fully reflect all available information and expectations, so current prices are the best approximation of a company’s intrinsic value. This would preclude anyone from exploiting mispriced stocks on a consistent basis because price movements are largely random and driven by unforeseen events. Sharp and Malkiel concluded that, due to the short-term randomness of returns, investors would be better off investing in a passively managed, well-diversified fund. In his book, Malkiel theorized 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 experts."

Enter the Dart-Throwing Monkeys

In 1988, the Wall Street Journal created a contest to test Malkiel's random walk theory by creating the annual Wall Street Journal Dartboard Contest, pitting professional investors against darts for stock-picking supremacy. Wall Street Journal staff members played the role of the dart-throwing monkeys. After 100 contests, the Wall Street Journal presented the results, which showed the experts won 61 of the contests and the dart throwers won 39. However, the experts were only able to beat the Dow Jones Industrial Average (DJIA) in 51 contests. Malkiel commented that the experts' picks were aided by the publicity jump in the price of a stock that tends to occur when stock experts make a recommendation. Passive management proponents contend that, because the experts could only beat the market half the time, investors would be better off investing in a passive fund that charges far lower management fees.

RELATED TERMS
  1. Random Factor Analysis

    Random factor analysis is a statistical technique to decipher ...
  2. Weak Form Efficiency

    One of the different degrees of efficient market hypothesis (EMH) ...
  3. Data Smoothing

    The use of an algorithm to remove noise from a data set, allowing ...
  4. Contestable Market Theory

    Contestable market theory is an economic concept that refers ...
  5. Strong Form Efficiency

    The strongest version of market efficiency. It states all information ...
  6. Runs Test

    A runs test is a statistical technique to test the hypothesis ...
Related Articles
  1. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  2. Trading

    Random Reinforcement: Why Most Traders Fail

    This phenomenon can cause a trader to abandon a proven strategy or risk everything on chance.
  3. Investing

    10 Books Every Investor Should Read

    Want advice from some of the most successful investors of all time? Check out our reading list.
  4. Insights

    Dow Theory

    Learn about the foundation upon which technical analysis is based.
  5. Investing

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
RELATED FAQS
  1. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  2. How is the Dow Jones Industrial Average used in the Dow theory?

    Discover how the Dow Jones Industrial Average is used in the Dow Theory, which is used by traders to figure out the trend ... Read Answer >>
  3. What are the disadvantages of using a simple random sample to approximate a larger ...

    Learn what a simple random sample is, how researchers use it as a statistical tool and the disadvantages it carries when ... Read Answer >>
  4. What's An Example of Stratified Random Sampling?

    Stratified random sampling divides a population into subgroups or strata, whereby the members in each of the stratum formed ... Read Answer >>
  5. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
Hot Definitions
  1. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  2. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  3. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  4. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  5. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
  6. Cash Conversion Cycle - CCC

    Cash conversion cycle (CCC) is a metric that expresses the length of time, in days, that it takes for a company to convert ...
Trading Center