The random walk theory asserts that stock market’s price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements.
Much of the theory on these subjects can be traced to French mathematician Louis Bachelier whose Ph.D. dissertation titled “The Theory of Speculation” (1900) included some remarkably insights and commentary.
Bachelier came to the conclusion that “The mathematical expectation of the speculator is zero” and he described this condition as a “fair game.”
Unfortunately, his insights were so far ahead of the times that they went largely unnoticed for over 50 years until his paper was rediscovered and published in 1964.
Combining the Random Walk Theory together with the Efficient Market Hypothesis we can conclude that we can have three forms of the Hypothesis:
1. The Weak Form:
It asserts that all past market prices and data are fully reflected in securities prices. In other words, technical analysis is of no use.
2. The Semistrong Form:
It asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use.
3. The Strong Form:
It asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use.
The paradox of efficient markets is that if every investor believed a market was efficient, then the market would not be efficient because no one would analyze securities!
In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market!
In reality, markets are neither perfectly efficient nor completely inefficient. All markets are efficient to a certain extent, some more so than others. Rather than being an issue of black or white, market efficiency is more a matter of shades of gray!
In markets with substantial impairments of efficiency, more knowledgeable investors can strive to outperform less knowledgeable ones.
The efficient market debate plays an important role in the decision between active and passive investing. Active managers argue that less efficient markets provide the opportunity for outperformance by skillful managers.
However, its important to realize that a majority of active managers in a given market will underperform the appropriate benchmark in the long run whether markets are or are not efficient.
This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose.
However, when costs are added, even marginally successful active managers may underperform!