stockmarketwalk Definition
The Random Walk Theory states that the price movements on the stock market are not predictable. The reason is they are determined randomly by unexpected events without any correlation to the past.
Like the efficient market hypothesis, the random walk theory assumes that past movement in the stock market cannot be a basis for predicting future movements.
It states it is not possible to outperform the performance of market without assuming additional risk. It believes that the technical analysis is undependable because chartists only buy/sell a security after trend has developed. Similar to that, the theory considers the fundamental analysis unreliable due to the often-poor quality of information gathered and its potential for misinterpretation.
Brief history
The theory goes back 150 years when the French broker Jules Regnault published his book Calcul des Chances et philosophie de la Bourse about the random determination of prices. 100 years later in 1964, one of the MIT professors, Paul Cootner, developed the same thoughts in his book, The Random Character of Stock Market Prices.
Finally, the book Random Walk Down Wall Street published in 1973 by Burton Malkiel (a Professor at Priceton University) brought the theory into popularity. Malkiel cooperated with Eugen Fama while developing the ideas, who is the inventor of the theory of efficient markets.
The Random Walk Theory in practice
The Wall Street Journal devised a contest in 1988 to test the theory under real term condition. In this contest, professional investors working at the New York Stock Exchange competed against dummy investors. The dummy investors consisted of the Wall Street Journal employees who made decision of which stocks to pick by throwing darts at a board. After 100 rounds, the Wall Street Journal published the result of the contest.
The professional investors won 61 times of the contests, compared to the dart-throwing dummies who won 39 contests. But the professional investors were only able to beat the Dow Jones Industrial Average DJIA 51 times out of 100.
Malkiel commented on the result that the stocks picked by the experts benefited from publicity jump. It occurs when stock experts publicly make a recommendation. This could lead to higher stock prices of experts’ pick. Those who believe in this theory advocate passively managed, well-diversified funds due to the low risk and management fees.
What is the random walk problem? – Criticism
Numerous actors participate in the stock market, each stock market player spends a different amount of time in the market, leading to information asymmetry among them. Thus, short-term trends are possible to develop, and investors with up-to-date information knowledge can outperform the market.
Furthermore, the theory assumes that the market will correct itself as soon as new information is released. However, it can take some time for stock prices to stabilize, especially for securities with low trading volume.
Other critical aspect says the stock prices follow patterns or trends in the short, medium, or even long term. The price of security can be influenced by wide range of factors. Thus, identifying the pattern or trend followed by the price may be difficult. However, this difficulty cannot lead to the conclusion that the trend does not exist at all.
Conclusion
Random Walk theory assumes that unexpected events influence the prices in stock market without any correlation to the past. Therefore, prediction the future movements is not possible relying just on past information. It is not possible to outperform the market without assuming additional risk, technical as well as fundamental analysis are undependable. Those who believe in this theory prefer passive, well-devised investment strategy with low risk and management fees.
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