Random walk theory definition

What is random walk theory?

Random walk theory is a financial model which assumes that the stock market moves in a completely unpredictable way. The hypothesis suggests that the future price of each stock is independent of its own historical movement and the price of other securities.

Random walk theory assumes that forms of stock analysis - both technical and fundamental - are unreliable.

Background to the random walk theory

Random walk theory was first coined by French mathematician Louise Bachelier, who believed that share price movements were like the steps taken by a drunk; unpredictable.

However, the theory became famous through the work of economist Burton Malkiel, who agreed that stock prices take a completely random path. So, the probability of a share price increasing at any given time, is exactly the same as the probability that it will decrease. In fact, he argues that a blindfolded monkey could randomly select a portfolio of stocks that would do just as well as a portfolio carefully selected by professionals.

Random walk theory has been likened to the efficient market hypothesis (EMH), as both theories agree it is impossible to outperform the market. However, EMH argues that this is because all of the available information will already be priced into the stock’s price, rather than that markets are disorganised in any way.

Random walk theory: implications for traders

Traders that adhere to the random walk theory will believe that it is impossible to outperform the stock market and attempting to do so would incur large amounts of risk. Believers in the hypothesis tend to take a buy and hold strategy, as the theory suggests that longer-term positions will have the most chance of success.

The traders will look to hold a diverse selection of shares that best represent the entire stock market – exchange traded funds (ETFs) and indices are popular instruments, as they track a range of companies’ share prices.

Criticisms of random walk theory

Critics of random walk theory argue that it is possible to outperform the market through careful consideration of entry and exit points – this just takes a significant amount of time, effort and understanding.

Through careful analysis – whether its fundamental or technical – and research into each position you want to open, they believe it is possible to identify trends and patterns amongst the chaotic market movements. There will always be an element of random market behaviour, but traders can mitigate the risk of unpredictable movements with a risk management strategy.