What is Weak Form Efficiency?
Weak form efficiency claims that past price movements, volume, and earnings data do not affect a stock’s price and can’t be used to predict its future direction.
Weak form efficiency is one of the three different degrees of efficient market hypothesis (EMH).
Key Takeaways
- Weak form efficiency states that past prices, historical values, and trends cannot predict future prices.
- It posits that stock prices reflect all current information.
- Advocates see limited benefit in using technical analysis or financial advisors.
The Basics of Weak Form Efficiency
Weak form efficiency, also known as the random walk theory, states that future securities’ prices are random and not influenced by past events. Advocates believe all current information is reflected in stock prices and past information has no relationship with current market prices.
The concept of weak form efficiency was pioneered by Princeton University economics professor Burton G. Malkiel in his 1973 book, “A Random Walk Down Wall Street.” The book also covers other aspects of the efficient market hypothesis, such as semi-strong form efficiency and strong form efficiency.
Uses for Weak Form Efficiency
The key principle of weak form efficiency is that the randomness of stock prices makes it impossible to find price patterns and take advantage of price movements. Daily stock price fluctuations are entirely independent of each other, assuming that price momentum does not exist. Additionally, past earnings growth does not predict future earnings growth.
Due to its principles, weak form efficiency suggests that technical analysis is inaccurate and even fundamental analysis can sometimes be flawed. It’s therefore extremely difficult to outperform the market, especially in the short term. Investors who adhere to weak form efficiency believe they can randomly pick investments or portfolios and achieve similar returns without needing active management or financial advisors.
Real-World Example of Weak Form Efficiency
Suppose David, a swing trader, notices Alphabet Inc.’s stock continually declines on Mondays and increases in value on Fridays. He may assume he can profit by buying the stock at the beginning of the week and selling at the end. However, if Alphabet’s price declines on Monday but does not increase on Friday, the market is considered weak form efficient.
Similarly, let’s assume Apple Inc. has consistently beaten analysts’ earnings expectations in the third quarter over the last five years. Jenny, a buy-and-hold investor, purchases the stock a week before it reports this year’s third quarter earnings, anticipating a price rise. Unfortunately for Jenny, the company’s earnings fall short of expectations. According to weak form efficiency, the market doesn’t allow Jenny to earn an excess return based on historical earnings data.
Conclusion
In summary, weak form efficiency asserts that it is impossible to predict future stock price movements based on past price data. This aligns with the concept that stock prices reflect all current information. Recognizing the principles of weak form efficiency can significantly impact investment strategies, highlighting the limitations of technical analysis while questioning the value of active management.
Related Terms: efficient market hypothesis, semi-strong form efficiency, strong form efficiency, technical analysis, random walk theory.
References
- Burton Gordon Malkiel. “A Random Walk Down Wall Street: The Time-tested Strategy for Successful Investing”, Page 100. W.W Norton & Company, 2007.
