Random walk theory is used to model prices of shares. The theory follows that stock price changes are independent of each other, so the past movement or any trends of a particular stock cannot be used to predict the future of that stock.

This theory is founded on the randomness of economics and the market. It suggests the idea that the stock market takes an unpredictable path because the past does not necessarily have any relationship to the future. Stock brokers and traders who follow the random walk theory believe that to out-perform the market, one must take on an additional risk.

History of Random Walk Theory

The theory itself took shape in 1900 when a French mathematician named Louis Bachelier wrote his Ph.D. dissertation entitled, “The Theory of Speculation.” However, his ideas were so advanced that they were essentially ignored until the 1960s, when his paper was rediscovered and published.

Bachelier’s theorem was expounded on by Burton Malkiel, who, in 1973, published the book A Random Walk down Wall Street. The book has become a classic within the investment world, due to its approach to the randomness of the stock market. Malkiel’s book states that it is a waste of time to use technical or fundamental analysis when determining the movement of stocks. The theory assumes that such analysis is unproven when it comes to outperforming the markets. Random walk theory does promote the idea that traders should use a long-term buy and hold strategy, rather than trying to time the market’s movements.

Opposition

Detractors of the theory believe that it is outdated today, largely because of the changes in technology. Information about stock movement is available instantly. Anyone can use a computer to watch the stock market trends, and individuals have more control over their investments. Random walk theory was never popular among those on Wall Street because it condemns stock picking and analysis, both of which are the heart-and-soul of Wall Street operation. Many investors believe that changes in the stock market prices aren’t completely random and that trading systems can be developed and manipulated to exploit deviations from random walk theory.