Random walk theory

Random walk theory

 

—  Random walk theory is a financial model which assumes that the stock market moves in a completely unpredictable way. The hypothesis suggests that the future price of each stock is independent of its own historical movement and the price of other securities.

—  Random walk theory assumes that forms of stock analysis - both technical and fundamental - are unreliable.

—  The implication for traders is that it is impossible to outperform the overall market average other than by sheer chance.

 

Random walk vs Efficient Market Hypothesis (EMH)

—  Random walk theory has been likened to the efficient market hypothesis (EMH), as both theories agree it is impossible to outperform the market. However, EMH argues that this is because all of the available information will already be priced into the stock’s price, rather than that markets are disorganised in any way.

 

Basic Assumptions of the Random Walk Theory

1. The Random Walk Theory assumes that the price of each security in the stock market follows a random walk.
2. The Random Walk Theory also assumes that the movement in the price of one security is independent of the movement in the price of another security.

 

History

In 1964, American financial economist Paul Cootner published a book entitled “The Random Character of Stock Market Prices.” Considered a classic text in the field of financial economics, it inspired other works such as “A Random Walk Down Wall Street” by Burton Malkiel (another classic) and “Random Walks in Stock Market Prices” by Eugene Farma.

 

Implications of the Random Walk Theory

Since the Random Walk Theory posits that it is impossible to predict the movement of stock prices, it is also impossible for a stock market investor to outperform or “beat” the market in the long run. It implies that it is impossible for an investor to outperform the market without taking on large amounts of additional risk.

As such, the best strategy available to an investor is to invest in the market portfolio, i.e., a portfolio that bears a resemblance to the total stock market and whose price reflects perfectly the movement of the prices of every security in the market.

A flurry of recent performance studies reiterating the failure of most money managers to consistently outperform the overall market has indeed led to the creation of an ever-increasing number of passive index funds.

 Advantages of Random Walk Theory

·         It provides a cost-effective way of investing. That is an investment in ETFs.

·         In many situations market has not acted as predicted, which proves that stock prices are indeed random.

Disadvantages of the Random Walk Theory

·         Markets are not entirely efficient. Information asymmetry is there, and many insiders react much early than other investors due to the information edge.

·         In many cases, stock prices have shown trend year on year.

·         One lousy news affects a stock price for several days, even months.

 

A Non-Random Walk

In contrast to the Random Walk Theory is the contention of believers in technical analysis – those who think that future price movements can be predicted based on trends, patterns, and historical price action. The implication arising from this point of view is that traders with superior market analysis and trading skills can significantly outperform the overall market average.

Conclusion

So, who do you believe? If you believe in the Random Walk Theory, then you should just invest in a good ETF or mutual fund designed to mirror the performance of the S&P 500 Index and hope for an overall bull market.

If, on the other hand, you believe that price movements are not random, then you should be polishing your fundamental and/or technical analysis skills, confident that doing such work will pay off with superior profits through actively trading the market.