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The random walk theory claims that the future movements of stock prices cannot be predicted based on past movements. While admitting that long-term market prices do rise, it states that short-term movements are practically random and unpredictable. It rejects both technical analysis and fundamental analysis as valid tools for predicting stock behavior. Proponents of the random walk theory typically advocate long-term investing rather than trying to time the market.
Though the theory was first investigated in 1953, it didn’t gain popularity until the book A Random Walk Down Wall Street was published by American economist Burton Malkiel in 1973. The theory essentially states that market prices follow a random path up and down, much like the random walk mathematical function. In a random walk function, a trajectory is determined by a succession of random steps, either up or down. It can accurately describe a number of natural phenomena, including the paths of gas molecules and animals alike. This random behavior is what proponents of the random walk theory see in stock charts.
Advocates of the theory typically do agree that market prices will rise in the long term. They recommend investors employ a buy-and-hold strategy rather than try to time the market. While advocates of the theory agree that it is possible to outperform the market, they claim that this only comes with risk attached. It is impossible to eliminate this inherent risk no matter how well-informed an investor is, says the random walk theory.
On the other hand, technical analysis is the study of stock performance based on past trends. Technical analysts typically attempt to use a stock’s price and volume history to forecast the stock’s future movements. They claim that investors are not the rational agents that many economists make them out to be, but rather they are influenced by emotions, cognitive errors and arbitrary preferences. This inherent irrationality, technical analysts claim, leads to predictable behavior. Supporters of the random walk theory reject these claims, asserting that such trends would be self-defeating as soon as investors recognized them.
Another challenge to the random walk theory is fundamental analysis. Though quite different from technical analysis, it is also rejected by proponents of the random walk theory. Fundamental analysis looks at a business’s prospects—its products offered, financial health, business plan, competitors, etc.—as a means of determining its future stock performance. It tends to assume that markets will behave in an efficient, rational way and that they will adjust quickly.