Weak Form Efficiency

DEFINITION of 'Weak Form Efficiency'

Weak form efficiency is one of the three different degrees of efficient market hypothesis (EMH); it claims that past price movements and volume data do not affect stock prices. As weak form efficiency is theoretical in nature, advocates assert that fundamental analysis can be used to identify undervalued and overvalued stocks. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.

BREAKING DOWN 'Weak Form Efficiency'

Weak form efficiency, also known as the random walk theory, states that future securities' prices are random and not influenced by past events. Advocates of weak form efficiency believe all current information is reflected in stock prices and past information has no relationship with current market prices.

The idea of weak form efficiency was pioneered by Princeton economics professor Burton G. Malkiel in his 1973 book "A Random Walk Down Wall Street." The book, in addition to touching on random walk theory, describes the efficient market hypothesis and the other two degrees in which stock prices reflect past, present and future information.

How Weak Form Efficiency Can Be Used

The main tenet of weak form efficiency is the randomness of stock prices makes it impossible to find price patterns and take advantage of price movements. Specifically, daily stock price movements are completely independent of each other, and it is assumed price momentum does not exist. Additionally, past earnings growth does not predict current or future earnings growth.

Weak form efficiency does not consider technical analysis to be accurate and asserts that even fundamental analysis, at times, can be flawed. It is therefore extremely hard, according to weak form efficiency, to outperform the market, especially in the short term. For example, if a person agrees with this type of efficiency, he believes there is no point to a financial advisor or active portfolio manager. Instead, investors who advocate for weak form efficiency assume they can randomly pick an investment or a portfolio with little risk.

Markets that are weak form efficient do not follow patterns. If, for example, a trader sees a stock continuously decline on Mondays and increase in value on Fridays, he may assume he can profit if he buys the stock at the beginning of the week and sells at the end of the week. If, however, the price declines on Monday but does not increase on Friday, the market can be considered weak form efficient.

Efficient Market Hypothesis

The other two degrees of efficient market hypothesis are semi-strong form efficiency and strong form efficiency. Unlike weak form, both of these forms believe that past, present and future information affects stock price movements to varying degrees.