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.

  1. Random Factor Analysis

    A statistical analysis performed to determine the origin of random ...
  2. Data Smoothing

    The use of an algorithm to remove noise from a data set, allowing ...
  3. Runs Test

    A statistical procedure that examines whether a string of data ...
  4. Passive Management

    A style of management associated with mutual and exchange-traded ...
  5. Simple Random Sample

    A subset of a statistical population in which each member of ...
  6. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
Related Articles
  1. Investing

    Viewing The Market As Organized Chaos

    Find out how a cat and a ladybug prove markets are both random and efficient.
  2. Investing

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  3. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  4. Trading

    Random Reinforcement: Why Most Traders Fail

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

    10 Books Every Investor Should Read

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

    Is Stock Picking a Myth?

    Can mutual fund managers successfully pick stocks, or are you better off with an index fund?
  7. Insights

    Dow Theory

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

    Strategies For Determining The Market's True Worth

    Learn the strengths and weaknesses of passive and active management when trying to uncover the overall market's worth.
  1. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  2. What are the advantages of using a simple random sample to study a larger population?

    Learn how simple random sampling works and what advantages it offers over other sampling methods when selecting a research ... Read Answer >>
  3. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
Hot Definitions
  1. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  2. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  3. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  5. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  6. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
Trading Center