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Random Walk in Economics: Definition & Theory

Instructor: Brianna Whiting

Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.

In this lesson we will discuss the concept of 'random walk' in economics. We will define the term and look at some exceptions. We will consider why random walk is important and then conclude with a summary and a quiz.

A First Look at Random Walk

Meet Mark! Mark has always been proficient at his job working for the tire factory. While the job has always provided for his family, Mark does not earn any surplus income to do much with. That is, until Mark decided to buy a lottery ticket one day and ended up winning! Ideas of what to do with the money flooded his head, but one thing he knew for sure was that he wanted to invest some of his money in the stock market. Having never played the stock market before, Mark entrusted his money with a financial advisor. Mark explained that he wanted to invest in only those stocks that were safe and predictable. Unfortunately, Mark's financial advisor had to inform him that due to the random walk theory this would be difficult to achieve.

Definition

So what exactly is the random walk theory? Well, this theory suggests that stocks are random and unpredictable, and that past events are of no influence on future movements. Therefore, it is not possible to find patterns. The daily prices of stock are independent of each other, so trying to calculate future growth based on past earnings is pointless.

Plausible Exceptions

While the theory states that it is impossible to predict the future of stocks based on past activity, there are a few exceptions to consider. They are as follows:

  • Smaller stocks tend to have some relationship between prices in the short term, because information about the stock does not get incorporated into the price of the stock as quickly.
  • The season tends to affect the trend of the stock market. This is particularly true at both the beginning and the end of the year.
  • Stocks that are high-dividend provide higher returns because even in a down market there is a demand for these types of stocks, which helps to increase the price.

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