The Random Walk Hypothesis (RWH) suggests that stock prices move in a completely unpredictable manner, making it impossible to consistently outperform the market through stock selection or market timing. According to this hypothesis, changes in stock prices are independent of each other and follow a random path, meaning past price movements or trends cannot be used to forecast future prices. This concept supports the idea of market efficiency, where all available information is already reflected in stock prices, leaving no room for systematic exploitation.
Basically, the random walk hypothesis comprises two main ideas,
- It states that consecutive returns are independent, meaning the correlation between returns in one period and the next is zero.
- It also claims that the return distribution remains the same across all periods, implying, for example, that the probability of a 50% loss is consistent in every period.
Studies and tests have been designed to verify the validity of the Random Walk Hypothesis. Among these, the variance ratio test proposed by Lo and MacKinlay [1] is the most widely used. Reference [2] applied the variance ratio test to examine the RWH in the Nigerian market. The authors also tested for stationarity, which is part of the procedure for assessing the RWH. The authors pointed out,
The variance ratio statistic for each of the company is associated with probability value of 0%. This suggests the rejection of the null hypothesis of sustainable random process. Therefore, our test evidence shows that the returns of these companies are not random; rather they are stationary and predictable.
The VR tests assumption are strongly rejected with marginal p-values of 0.0000. This means that the NSE stock returns do not follow a random walk. Based on the results of variance ratio tests, it is concluded that the Nigerian daily stock return series do not move in a random fashion and hence the null hypothesis of a random walk is rejected, thus the Nigerian Stock Market is a weak-form inefficiency market.
In short, they concluded that the Nigerian market is not random but rather stationary and predictable.
This paper employed well-established procedures to test the RWH in an emerging market, serving as a reminder of how to effectively perform an RWH test.
Let us know what you think in the comments below or in the discussion forum.
References
[1] Lo, A. W. & MacKinlay, A. C. (1988), Stock prices do not follow random walks: evidence from a simple specification test, Review of Financial Studies 1, 41-66
[2] A. Chukwuemeka, A. Azubuike Samuel, Variance Ratio Tests of Random Walk Hypothesis of Stock Return in Nigeria: Further Evidence, International journal of business and management research, Vol. 5, No.2, September 2024
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