Random walk theory
Random walk theory suggests that the future price movements of financial assets, like stocks, are unpredictable and resemble a random path. Imagine a drunkard taking steps in different directions; each step is independent of the last. This means that past prices don’t reliably indicate future prices, making it challenging to consistently predict market movements. The theory implies that strategies based on historical data may not be effective in generating excess returns, supporting the idea that markets are generally efficient and reflect all known information at any given time.
Additional Insights
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Random Walk Theory suggests that stock prices move in unpredictable ways, akin to a person taking random steps. It posits that future price changes are independent of past movements, implying that it’s impossible to consistently predict market trends based on historical data. This theory is often used to justify the idea that stock market investments are fundamentally risky and that actively trying to outperform the market, like through stock picking, may not yield better results than simply investing in a diversified portfolio.