What Is Weak Form Efficiency?
Let me explain weak form efficiency to you directly: it's a financial theory that insists past price movements, trading volumes, and earnings data have no impact on a stock's future price and can't help you predict where it's headed.
You should know that weak form efficiency is one of the three levels in the efficient market hypothesis (EMH).
Key Takeaways
- Weak form efficiency states that past prices, historical values, and trends can’t predict future prices.
- Weak form efficiency is an element of efficient market hypothesis.
- Weak form efficiency states that stock prices reflect all current information.
- Advocates of weak form efficiency see limited benefit in using technical analysis or financial advisors.
The Basics of Weak Form Efficiency
I want you to understand that weak form efficiency, which you might also hear called the random walk theory, holds that future prices of securities are random and unaffected by past events. If you support this view, you believe all current information is already baked into stock prices, and past data has no connection to what's happening in the market now.
This idea came from Princeton economist Burton G. Malkiel in his 1973 book 'A Random Walk Down Wall Street.' In it, he covers random walk theory, the efficient market hypothesis, and the other two levels: semi-strong form efficiency and strong form efficiency. Unlike weak form, those other forms argue that past, present, and future information influences stock prices to different extents.
Uses for Weak Form Efficiency
Here's the core of weak form efficiency: the randomness of stock prices means you can't spot patterns to exploit price movements. Daily fluctuations are completely independent, so there's no such thing as price momentum. Also, past earnings growth doesn't tell you anything about current or future growth.
From this perspective, technical analysis isn't reliable, and even fundamental analysis can be off sometimes. That's why weak form efficiency suggests it's very hard to beat the market, especially short-term. If you buy into this, you might think there's no value in hiring a financial advisor or active manager. Instead, you'd just pick investments randomly or build a portfolio, expecting similar returns either way.
Real-World Example of Weak Form Efficiency
Consider this scenario: David, a swing trader, notices Alphabet Inc. (GOOGL) dropping on Mondays and rising on Fridays. He figures he can buy at the week's start and sell at the end for profit. But if the price drops Monday and doesn't rise Friday, that shows the market is weak form efficient.
Or take Jenny, a buy-and-hold investor, who sees Apple Inc. (AAPL) beating earnings expectations in the third quarter for five straight years. She buys the stock a week before this year's report, expecting a price jump. When earnings miss and the price doesn't rise, it demonstrates weak form efficiency, as she couldn't earn excess returns from historical data.
Note
Remember, this information isn't tax, investment, or financial advice. It's presented without regard to your specific objectives, risk tolerance, or circumstances, and it may not suit all investors. Investing carries risks, including potential loss of principal.
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