How the Efficient Market Hypothesis Relates to Random Walks
Summary
The document distinguishes the efficient market hypothesis from random walk theory and describes a conditional link between them. Under an efficient-market view, available information is reflected in prices; as new information arrives unpredictably, price changes may behave like a random walk. This relationship does not make the two ideas identical: the efficient market hypothesis is broader and concerns how information and expected returns relate to prices.
The responses also contrast their return assumptions. A simple random walk account is described as having zero expected return, while the efficient market hypothesis can allow positive expected returns as compensation for risk. The discussion notes that tests of market efficiency depend on the model used to estimate appropriate expected returns. These are conceptual distinctions rather than empirical tests, and the document offers no evidence that either framework holds universally.
Key ideas
- The efficient market hypothesis and random walk theory are related but distinct concepts.
- Unpredictable new information can lead to random price changes if available information is already reflected in prices.
- The discussion characterizes a simple random walk as having zero expected return, unlike risk-compensated expected returns under EMH.
- Tests of market efficiency depend on specifying an appropriate expected-return model.
Tags
Full text
# Do efficient market hypothesis and random walk theory convey the same concept?
# Do efficient market hypothesis and random walk theory convey the same concept?
According to investopedia efficent market hypothesis is
> The efficient market hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information...
and random walk theory (RWT) is
> Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement..
Does both concepts convey the same message but presented as different way? Or EMH and RWT are entirely different concepts?
## Answer by Andrew Maliska (score 6)
https://quant.stackexchange.com/a/25795
They are different concepts, and the relation between them can be described as a conditional: "if EMH holds (all available information about future price movements is already priced into the market), then future price movements will follow a purely random walk as new and unpredictable information emerges"
## Answer by nbbo2 (score 5)
https://quant.stackexchange.com/a/25796
Historically the RWT (Random Walk Theory) came first, as empirical observations by for example M.F.M. Osborne (1959) and others in the 1960s. The EMH came about as a result of theoretical work by Samuelson in 1965 ("Proof that properly discounted prices...") and E.Fama (1969) as a general empirical/theoretical hypothesis that guided the field for many decades. The EMH, in addition to this broader scope differs from the RWT as follows: in the RWT the expected return is zero, while in the EMH there is a non-zero expected return "as appropriate compensation the risk being taken", so as Fama always likes to say "tests of the EMH are conditional on a proper model for expected returns". In simple language, in the EMH you can still make money by holding stocks for the long run.
The expression Random Walk Theory is not much used nowadays in the literature, it has been pretty much supplanted by the EMH.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.