RANDOM WALK THEORY &

INVESTOR TYPES

By Monzur Morshed Patwary

Random Walk Theory The theory that stock price changes have

the same distribution and are independent of each other, so the past movement or trend of a stock price or market cannot be used to predict its future movement.

In short, random walk says that stocks take a random and unpredictable path.

Under the random walk theory, there is an equal chance that a stock's price will either rise or fall from current levels.

Random Walk Theory While EMT suggests that stock is always

efficiently priced this theory suggests that price behavior is never based on anything predictable, but is completely random.

The random walk theory is the belief that price behavior cannot be predicted because it does not act on any predictive fundamental or technical indicators.

Background of Random Walk Theory

Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic.

Originally examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are independent of each other and have the same probability distribution, but that over a period of time, prices maintain an upward trend.

Background of Random Walk Theory

random walk hypothesis, 1st espoused by French mathematician Louis Bachelier in 1900, which states that stock prices are random, like the steps taken by a drunk, and therefore are unpredictable.

A few studies appeared in the 1930’s, but the random walk hypothesis was studied and debated intensively in the 1960’s

Random Walk Theory Explained

Chartists and technical theorists believe historical patterns can be used to project future prices. While the random walk hypothesis claims that such movements cannot be accurately predicted.

I'll start by comparing random walk to other popular theories such as the efficient market hypothesis, fundamental analysis, and technical analysis.

Random Walk and Competing Theories

Generally, there are two competing approaches to predicting the movements of stocks: fundamental and technical analysis.

Fundamental Theoristso believe the price of a stock is a function of its

intrinsic value, which depends heavily on the future earnings potential for a company.

o factors such as industry trends, economic news, Global news and the company's earnings per share outlook, fundamental analyst can determine if the stock's price is above or below its intrinsic value.

o Comparing a stock's price to its intrinsic value allows the fundamental analyst to predict the potential future direction of the stock's price.

Technical Theoristso believe that historical movements of a

stock's price can be used to predict future price direction.

o Using methods such as charting, the technical analyst will examine the sequence of upward and downward movements for a stock.

o These patterns of movements allow the technical theorist to chart what they believe will be future movements for the stocks they are examining.

Random Walk and Efficient Market Theorists

EMH states that financial markets are efficient and that prices already reflect all known information concerning a stock or other security and that prices rapidly adjust to any new information.

Information includes not only what is currently known about a stock, but also any future expectations, such as earnings or dividend payments.

Random Walk and Efficient Market Theorists

It seeks to explain the random walk hypothesis by positing that only new information will move stock prices significantly, and since new information is presently unknown and occurs at random, future movements in stock prices are also unknown and, thus, move randomly.

Hence, it is not possible to outperform the market by picking undervalued stocks, since the efficient market hypothesis posits that there are no undervalued or even overvalued stocks.

Contradiction of Random Walk Theory

While many still follow the preaching of Malkiel, others believe that the investing landscape is very different than it was when Malkiel wrote his book nearly 30 years ago.

Today, everyone has easy and fast access to relevant news and stock quotes. Investing is no longer a game for the privileged.

Random walk has never been a popular concept with those on Wall Street, probably because it condemns the concepts on which it is based such as analysis and stock picking.

Contradiction of Random Walk Theory

The problem with the random walk theory is that it ignores the easily observed trends and momentum factors that do directly affect price movement.

Professors Andrew W. Lo and Archie Craig MacKinley (1999, A Non-Random Walk Down Wall Street), a series of tests demonstrated that at least some degree of predictability is present in stocks based on a comparison between price behavior and other influences (earnings, for example).

The same authors wrote a paper (2005, 'The Adaptive Market Hypothesis') in which financial activity (price behavior) is influenced not randomly, but by the same factors affecting evolution (competition, adaptation, and natural selection).

Practical Implications The random walk hypothesis has some

practical implications to investors. For example, since the short term

movement of a stock is random, there is no sense in worrying about timing the market. A buy and hold strategy will be just as effective as any attempt to time the purchase and sale of securities.

Practical Implications When investors buy stocks, they usually

do so because they believe the stock is worth more than they are paying.

In the same way, investors sell stocks when they believe the stock is worth less than the selling price.

If the efficient market theory and random walk hypothesis are true, then an investor's ability to outperform the stock market is more luck than analytical skill.