Random Walk Theory 

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Random Walk Theory

The random walk theory states that stock price movements are unpredictable, making it impossible to know where prices are headed. The random walk theory asserts that stock prices cannot be predicted from prior prices because no relationship exists between the two sets of prices. Events occur randomly, which then affect stock prices. An illustration of this theory is the flipping of a coin. The outcomes are not affected by previous throws.

Burton G. Malkiel, in his book, A Random Walk Down Wall Street (1990), argues that investors would do no better or worse than the market averages if they chose their investments by throwing darts at stock tables. The reason is that information about stocks occurs randomly, and then the stocks will react to the news. Bad news causes a stock’s price to go down immediately, and good news has an immediate positive effect on a stock’s price. The news about a stock cannot be anticipated accurately, which results in a random occurrence, meaning that stock prices move randomly. According to Dremen (1991), analysts were only accurate 40 percent of the time in forecasting the next quarter’s earnings for companies they followed. Thus stocks react in advance of anticipated good or bad news, and by the time the news is announced, it is already reflected in the stock price. The random walk theory implies that technical analysis is a waste of time in that prices cannot be predicted from historical data.

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