holding XYZ, however, would be willing to sell. The net ef- fect would be an immediate jump in the stock price to $110. The forecast of a future price increase will lead instead to an immediate price increase. In other words, the stock price will immediately reflect the "good news" implicit in the models forecast. This simple example illustrates why Kendalls attempt to find recurrent patterns in stock price movements was doomed to failure. A forecast about favorable future performance leads instead to favorable current performance, as market participants all try to get in on the action before the price jump. More generally, one might say that any information that could be used to predict stock performance should already be reflected in stock prices. As soon as there is any informa- tion indicating that a stock is underpriced and therefore offers a profit opportunity, in- vestors flock to buy the stock and immediately bid up its price to a fair level, where only ordinary rates of return can be expected. These "ordinary rates" are simply rates of return commensurate with the risk of the stock. However, if prices are bid immediately to fair levels, given all available information, it must be that they increase or decrease only in response to new information. New informa- tion, by definition, must be unpredictable; if it could be predicted, then the prediction would be part of todays information. Thus stock prices that change in response to new (un- predictable) information also must move unpredictably. This is the essence of the argument that stock prices should follow a random walk, that is, that price changes should be random and unpredictable. 2 Far from a proof of market ir- rationality, randomly evolving stock prices are the necessary consequence of intelligent in- vestors competing to discover relevant information on which to buy or sell stocks before the rest of the market becomes aware of that information. Dont confuse randomness in price changes with irrationality in the level of prices. If prices are determined rationally, then only new information will cause them to change, Therefore, a random walk would be the natural result of prices that always reflect all cur- rent knowledge. Indeed, if stock price movements were predictable, that would be damn- ing evidence of stock market inefficiency, because the ability to predict prices would indicate that all available information was not already reflected in stock prices. Therefore, the notion that stocks already reflect all available information is referred to as the efficient market hypothesis (EMH).3     2 Actually, we are being a little loose with terminology here. Strictly speaking, we should characterize stock prices as following a submartingale, meaning that the expected change in the price can be positive, presumably as compensation for the time value of money and systematic risk. Moreover, the expected return may change over time as risk factors change. Arandom walk is more restrictive in that it constrains successive stock returns to be independent and identically distributed. Nevertheless, the term "ran- dom walk" is commonly used in the looser sense that price changes are essentially unpredictable. We will follow this convention. 3 Market efficiency should not be confused with the idea of efficient portfolios introduced in Chapter 8. An informationally effi- cient market is one in which information is rapidly disseminated and reflected in prices. An efficient portfolio is one with the high- est expected return for a given level of risk.