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Random Walk Hypothesis

16 June 2008 - Features - Editor

The financial theory known as the "random walk hypothesis" proposes that stock market prices develop according to a random walk and, therefore, stock market prices are completely unpredictable. This hypothesis is widely accepted by economists, investors and other financial behaviorists, who continue to believe that stock prices are random making it impossible to consistently outperform market averages.

Economic and stock market analysts use random walk techniques as a model for the behavior of share prices on stock markets, as well as commodity prices and currency exchange rates. This practice presumes that investors act rationally and without bias, estimating the value of an asset based on expectations for the future. All existing information affects the share price, which can only change when new information becomes available. Since new information appears randomly, it follows that the share price is influenced randomly.

The term "random walk" was made popular in 1973 by Burton Malkiel’s book, "A Random Walk Down Wall Street". Malkiel, an economist professor at Princeton University, tested his random walk hypothesis by giving his students hypothetical stock valued at fifty dollars. Each day the closing stock price was determined by flipping a coin. If the coin came up heads, the stock price would close at a half point higher, but if the coin showed tails, the stock price would close at a half point lower. With each flip of the coin the price had a fifty-fifty chance of closing either higher or lower than the previous day. The results of the daily coin-flip were recorded in a chart and graph form which Malkiel took to a chartist - an analyst who attempts to predict future movements by interpreting past patterns, working on the assumption that history is inclined to repeat itself. On analyzing the data, the chartist recommended that they immediately buy the stock and was reportedly most unhappy when Malkiel revealed that all the data was based on the mere flip of a coin. This exercise is an indication that changes in stock prices could be just as random as the results of flipping a coin.

Critics of Malkiel’s random walk hypothesis point to investors such as Peter Lynch and Warren Buffet, who are both successful adherents of fundamental analysis. However, "A Random Walk Down Wall Street" is geared toward typical investors. The continued success of some professional investors could to a large extent be attributed to the availability of superior information, backed by financial power and long-standing top-level business relationships – advantages that typical investors do not have.

Professors Andrew Lo and Archie MacKinlay wrote the book "A Non-Random Walk Down Wall Street" in which they argue against the random walk hypothesis. They assert that even the casual observer would be able to see the trends in the many stock and index charts which have been generated over the years. They point to the fact that there have been many long rises and long declines in the market which they believe is a clear indication that the market is not random. Adherents to the random walk hypothesis, however, continue to believe that past performance cannot be a clear indicator of future performance and therefore, the random walk hypothesis applies.

 


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