Efficient Market Theory and Random Walk Theory

Efficient Market Theory

Stock prices are determined by a number of factors such as fundamental factors, technical factors and psychological factors. The behavior of stock prices is studied with the help of different methods such as fundamental analysis and technical analysis. Fundamental analysis seeks to evaluate the intrinsic value of securities by studying the fundamental factors affecting the performance of the economy, industry and companies. Technical analysis believes that the past behavior of stock prices gives an indication of the future behavior. It tries to study the patterns in stock price behavior through charts and predict the future movement in prices. There is a third theory on stock price behavior which questions the assumptions of technical analysis.

The basic assumption in technical analysis is that stock pie movement is quite orderly and not random. The new theory questions this assumption. From the results of several empirical studies on stock price movements, the advocates of the new theory assert that share price movements are random. The new theory came to be known as Random Walk Theory because of its principal contention that share price movements represent a random walk rather than an orderly movement.

Random Walk Theory

Stock price behavior is explained by the theory in the following manner. A change occurs in the price of a stock only because of certain changes in the economy, industry or company. Information about these changes alters the stock prices immediately and the stock moves to a new level, either upwards or downwards, depending on the type of information. This rapid shift to a new equilibrium level whenever new information is received is recognition of the fact that all information which is known is fully reflected in the price of the stock. Further change in the price of the stock will occur only as a result of some other new piece of information which was not available earlier. Thus, according to this theory, changes in stock prices show independent behavior and are dependent on the new pieces of information that are received but within themselves are independent of each other. Each price change is independent of other price changes because each change is caused by a new piece of information.

The basic premise in random walk theory is that the information on changes in the economy, industry and company performance is immediately and fully spread so that all investors have full knowledge of the information. There is an instant adjustment in stock prices either upwards or downwards. Thus, the current stock price fully reflects all available information on the stock. Therefore, the price of a security two days ago can in no way help in speculating the price two days later. The price of each day is independent. It may be unchanged, higher or lower from the previous price, but that depends on new pieces of information being received each day.

The random walk theory presupposes that the stock markets are so efficient and competitive that there is immediate price adjustment. This is the result of good communication system through which information can be spread almost anywhere in the country instantaneously. Thus, the random walk theory is based on the hypothesis that the stock markets are efficient. Hence, this theory later came to be known as the efficient market hypothesis (EMH) or the efficient market model.