Brief Historical Overview

To describe stock prices as a random walk suggests that price movements cannot be expected to follow any type of pattern. Or, put another way, price movements are independent of one another. In order to find a theory for such behavior, researchers developed the concept of efficient markets. As we discussed briefly in Chapter 7, the basic idea behind an efficient market is that the market price of securities always fully reflects available information. This means that it would be difficult, if not impossible, to consistently outperform the market by picking "undervalued" stocks.

Random Walks The first evidence of random price movements dates back to the early 1900s. During that period, statisticians noticed that commodity prices seemed to follow a "fair game" pattern. That is, prices seemed to move up and down randomly, giving no advantage to any particular trading strategy. Although a few studies on the subject appeared in the 1930s, thorough examination of the randomness in stock prices did not begin until 1959. From that point on, particularly through the decade of the 1960s, the random walk issue was one of the most keenly debated topics in stock market literature. The development of high-speed computers has helped researchers compile convincing evidence that stock prices do, in fact, come very close to a random walk.

Random Walks and Efficient Markets

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