Random Walk Hypothesis

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.


Stock Investing: Learning More about the Random Walk Hypothesis

Economic and stock market analysts use the random walk hypothesis to model patterns of share prices on the stock market, including commodity prices and currency exchange rates. This practice presumes that investors will act rationally and without bias, projecting an asset’s value based on future expectations. All the current information affects the price per share, which can only change when new data becomes available. Since new information appears randomly, it can be assumed that the price for a share is influenced randomly.

Testing the Random Walk Hypothesis

The term, “random walk,” was popularized in 1973 by Burton Malkiel in his book, “A Random Walk Down Wall Street.” Malkiel, an economics professor at Princeton University, tested his random walk hypothesis by giving students hypothetic shares of stock, each valued at $50.

 

Each day, the closing stock price was determined by flipping a coin. If the coin came up heads, the stock price had a 50-50 chance of closing either lower or higher than the previous day. The results of the daily coin-flip were recorded on a chart and graph, which Malkiel gave to a chartist. A chartist is an analyst who attempts to predict future movements by interpreting past patterns, working on the assumption that history is destined to repeat itself.

 

Upon analysis of the data, the chartist recommended that the hypothetical stock be purchased immediately. He was also reportedly unhappy to learn that the data he reviewed was based on the mere flip of a coin. This exercise was performed to show that changes in the stock price could be considered just as random as the results returned when flipping a coin.

 

Critics of Malkiel’s random walk hypothesis like to point out that investors, such as Warren Buffet and Peter Lynch, represent examples of investors who adhere to the principle of fundamental analysis.

However, according to random walk theorists, “A Random Walk Down Wall Street,” is directed to the typical investor. They believe that the continued success of some professional investors can, to a large degree, be attributed to the availability of superior data, and supported by long-standing business relationships and financial access and power – advantages that regular investors do not possess.

 

As an argument against the random walk hypothesis, Professors Andrew Lo and Archie MacKinlay wrote the book, “A Non-Random Walk Down Wall Street.” In this book, the authors assert that even a casual observer can see the trends in many index and stock charts that have been generated over the years.

They point to the fact that the market has seen many long rises and long displays – both, which they believe, clearly indicate that the market is not random. However, proponents of the random walk hypothesis still continue to believe that past stock market performance cannot be considered a clear indicator of future performance, and therefore the random walk hypothesis is valid and applicable.

 

Giving the Random Walk Hypothesis Further Weight

Therefore, if you choose to believe the random walk hypothesis, you must accept that individual shares of stock do not move in a way that allows investors to predict short-term stock movements in advance.

So, what type of stocks should be purchased if you choose to believe the random walk hypothesis? If this type of stock scenario makes sense to you, you might test the theory out by investing in a diversified index fund that is managed passively.

The random walk hypothesis directly opposes technical analyses, which are used to identify certain patterns in volumes and prices so stocks can be bought and sold at just the right time. The theory also dismisses the idea of fundamental analysis, which seeks to review companies and industry financials to recognize undervalued shares of stock.

Those who support the random walk hypothesis have basically turned the idea of investment management on its head, as random walk proponents do not adhere to the science of choosing stocks. They do not believe you can analyze the market to realize a return that goes above market indexes.

One activity that seemingly supported the random walk hypothesis was a contest that was formerly staged by the Wall Street Journal. The contest, which was held on a regular basis over a 14-year period, pitted stock specialists and their investment choices against dart throwers – entrants who “made their picks” by throwing darts at a stock table. The contest never revealed any conclusive results.

While the Wall Street contest never really proved or disapproved the random walk hypothesis, highly sophisticated computer algorithms might be able to do so. The trends the algorithms discover may only last a fractionated second. However, those quick discoveries might prove the random walk hypothesis wrong.

While academics have been unable to lend concrete evidence to the random walk hypothesis, fundamental analysts and technical analysts choose stocks by different, yet seemingly logical means.

For example, and as previously noted, fundamental analysts try to pinpoint the intrinsic value for a share of stock by reviewing a company’s financial information, the industry and the current economic climate.

On the other hand, technical analysts rely on volume data and a stock’s historical prices to forecast the direction on a stock’s pricing. In either case, the idea is to pick stocks that outperform the market or surpass a certain benchmark over time. A random walk hypothesis argues that these are fruitless conjectures – and that they only increase risk without the possibility of a reward.

What do you think? Is the random walk hypothesis nonsense? Are fundamental analyses or technical analyses helpful? Given the advancements in technology and the development of algorithms for identifying pricing and movement, time will tell if the random walk theory is truly relevant.

The flip of a coin tends to lend to the idea of stock investing as a big gamble. However, investors who look at stocks from a fundamental or technical perspective try to minimize risk by carefully analyzing their stock picks. Doing so allows them to lend some credibility to investing in the market. Even fundamentalist, Warren Buffet, was once a regular investor like every other guy or gal.