In Finance, what is a Random Walk?

A random walk is a financial theory regarding the impact of past or present movements of stock prices or even entire markets on future movements. Essentially, this theory holds that regardless of what may have taken place before, or is currently taking place, those movements cannot be utilized as a means of determining what will happen in the future. Instead, the marketplace is viewed as unpredictable or random, and it is impossible to attempt to stay ahead of current circumstances without taking on a higher amount of risk. Proponents of this theory tend to promote a reactive approach to market trends, where investors follow what is happening currently, changing course only as the market changes course.

The random walk theory gained considerable notice in 1973, when the concept was featured in a work entitled “A Random Walk Down Wall Street, by Buron Malkiel. Many in the financial world trace the origin of the term to 1964, when “The Random Character of Stock Market Prices” by Professor Paul Cootner was released. Over the years, the theory has gained a considerable number of proponents, who feel that the theory is in harmony with the concept of efficient market hypothesis.

While the concept of a random walk in investment markets is considered a sound approach by many in the investment community, it is not without its critics. Those who do not support the theory hold that it is possible to accurately assess past movements as well as current trends, and use that data to determine what turns a stock or a market will make in the future. Assuming those predictions are based on facts regarding past performance and are interpreted accurately, these critics believe it is possible to run ahead of the trend, and execute orders that make it possible to outperform the market. This is done by carefully crafting s strategy to execute sales and purchases as specific points in time, based on where the market is anticipated to be at each of those points.

For those who find the random walk a practical approach to investing, the emphasis is on the random and often unpredictable path that stock prices can take. The theory states that there is just as much chance that prices will move in a direction very different from a specific historical point as there is that they will perform in a similar manner. It is this random possibility that forms the basis for the idea of following rather than attempting to run ahead of the marketplace, and execute orders only as market shifts begin to take place, rather than trying to predict those shift in advance.