What is Random Walk Theory?
Random walk theory holds that share prices move in an unpredictable, random pattern and cannot be reliably forecast from past prices. It is closely linked to the efficient market hypothesis: if prices already reflect all available information, only new and unforeseeable information moves them, so daily changes look random.
How It Works
- Each price change is treated as independent of previous changes.
- Past patterns therefore have no predictive power for future prices.
- Technical analysis is, by this view, unable to deliver excess returns over the long run.
- Passive index investing follows naturally from the theory.
Saudi Context
Studies of the Saudi Tadawul index have found mixed evidence on random walk behavior, with periods of weak-form efficiency interrupted by anomalies around earnings seasons and major regulatory announcements.
Example
If a stock closes higher five days in a row, random walk theory says the probability it closes higher on the sixth day is still close to 50 percent, not biased by the streak.