Introduction
Many believe that historical stock prices of return can be an aid in predicting the future. Random walk theory poses this question, and the answer is not all that simple.
The evidence in the random-walk literature existed before the theory was developed. The answers were already there, what was needed was an outlay that could explain these results. After the initial occurances of the observed results, more results and more theories came into light. This led to a diversity of theories, generically known as the random-walk theory.
Meaning
Random walk theory is a mathematical model of the stock market. It is also known as the Random Walk Hypothesis. It suggests that changes in stock prices have the same distribution and are independent of each other.
Exponents of the theory believe that the prices of securities in the stock market evolve according to a random walk. Therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement.
In short, random walk theory proclaims that stocks take a random and unpredictable path that makes all methods of predicting stock prices futile in the long run.
A “random walk” is a statistical phenomenon where a variable follows no discernible trend and moves seemingly at random. The random walk theory, as applied to trading, most clearly laid out by Burton Malkiel, an economics professor at Princeton University, posits that the price of securities moves randomly (hence the name of the theory), and that, therefore, any attempt to predict future price movement, either through fundamental or technical analysis, is futile.
Assumptions to the Theory
- The price of each security in the stock market follows a random walk.
- 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.
The theory believes it’s impossible to outperform the market without assuming additional risk. It considers technical analysis undependable because chartists only buy or sell a security after an established trend has developed. Likewise, the theory finds fundamental analysis undependable due to the often-poor quality of information collected and its ability to be misinterpreted.
Critics of the theory contend that stocks do maintain price trends over time – in other words, that it is possible to outperform the market by carefully selecting entry and exit points for equity investments.
Criticism of the Theory
One of the major setbacks was to the theory by the critics was the existence of a large variety of scattered participants in terms of capital investment. Therefore, it was very much possible that trends emerge in the prices of securities in the short run, and a savvy investor can outperform the market by strategically buying stocks when the price is low and selling stocks when the price is high within a short time span.
Also, others pointed out that the theory is flawed and that stock prices do follow patterns, even over the long run. They argued that because the price of a security is affected by an extremely large number of factors, it may be impossible to discern the pattern or trend followed by the price of that security. However, just because a pattern cannot be clearly identified, that doesn’t mean that a pattern does not exist.
Random Walk Theory in Practice
In 1988, the Random Walk Theory was put to the test in the famous Dart Throwing Investment Contest. Devised by the Wall Street Journal, this contest pitted professional investors working out of the New York Stock Exchange against dummy investors. The dummy investors consisted of the Wall Street Journal staff who chose stocks by throwing darts at a board.
The experiment, titled “The Wall Street Journal Dartboard Contest,” gained much fanfare and media attention. Out of 100 contests, the professional investors won 61, whereas the dart-throwing dummies won 39. However, the professional investors only beat the market (as represented by the performance of the Dow Jones Industrial Average) 51 times out of 100.
Non- Random Walk Theory
This 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.