What is Weak Form Efficiency?

Definition: Weak form efficiency, also known as the random walk theory, holds that the historical data of a stock do not affect its price. Therefore, projecting the future values is not improved by knowing the historical values.

What Does Weak Form Efficiency Mean?

What is the definition of weak form efficiency? The weak form efficiency is one of the three types of the efficient market hypothesis (EMH) as defined by Eugene Fama in 1970. Unlike the semi-strong form of EMH and the strong form of EMH, the weak form EMH considers that stock prices are arbitrary, and there are no patterns based on price movements. It also holds that stock price movements are independent, and there is no price momentum. Technical analysis that uses the past price movements to predict the future ones is useless. Only fundamental analysis and insider trading are allowed with the prospect of beating the market in the long-term.

Let’s look at an example.

Example

A market is efficient when all information disseminated directly therein is fully reflected in stock prices, thus eliminating the possibility of abnormal profits, i.e. profits generated by investment returns that far exceed the returns of the market. A market is weakly efficient when investors cannot realize abnormal profits by using information such as stock prices and security yields, trading volumes and sales transactions.

Ian is a novice investor who has recently developed an interest in investment trading. He is not so experienced, and he wants to collect historical data on the stocks he owns in order to earn an excess return. What should Ian do?

Ian observes that the price of a particular stock lost 5% on Monday and earned 3% on Friday. So, Ian decides to purchase 100 shares of this stock for $10 per share. The stock continues to fluctuate, and Ian needs to compare the stock’s current performance with its past performance. Following the technical analysis patterns, he comes to no concrete conclusion. Is the market, perhaps weakly efficient?

The answer is yes. The market is weakly efficient because it does not allow Ian to earn an excess return by picking stocks based on their past performance and historical data.

Summary Definition

Define Weak Form Efficiency: Weak form efficiency is an investment analysis theory that states future stock prices cannot be readily estimated by past prices or historical values and trends.