Random walk theory

In the following article, we will discuss the definition of random walk theory, go through details about how it’s used in trading and provide an example for better understanding.

What is the random walk theory?

According to the random walk theory, stock price fluctuations have about an identical distribution and thus are unrelated to one another. As a result, it is presumptive that a share value or market’s historical movement or trends can’t be utilized to forecast its future course. In essence, the random walk theory holds that stocks follow a completely unpredictable route, rendering all share value prediction techniques useless.

Key takeaways

According to the random walk theory: 

• It is impossible to beat the market without taking on additional risk.
• The past stock price movement can’t be used to forecast its future movement.
• Technical analysis is unreliable since chartists typically purchase or trade security after the move has already taken effect.
• Stock price fluctuations have a uniform distribution and, thus, are unrelated.
• Fundamental analysis is deemed unreliable because of the frequently unsatisfactory information gathered and its susceptibility to misinterpretation.

Also, followers of the random walk theory believe that a client’s portfolio gains next to nothing by using a financial planner.

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Understanding random walk theory

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Since chartists only sell or purchase security once a well-established trend has emerged, it believes technical analysis to be unreliable. The theory also considers fundamental analysis unreliable, given the frequently mediocre quality of data gathered and its susceptibility to misinterpretation.

Critics of the theory argue that stocks maintain price trends over time. They are convinced that the market can be beaten by carefully choosing entry and exit points for investing in stocks.

Efficient markets are random

When writer Burton Malkiel first used the phrase in his work “A Random Walk Down Wall Street” in 1973, it caused astonishment. The efficient market hypothesis (EMH), a prior theory by professor William Sharp, gained popularity thanks to this book. According to the EMH, stock prices accurately represent all information and expectations, making today’s rates the closest measure of a firm’s inherent value. It would make it impossible for anybody to profit regularly from mispriced equities because those fluctuations are typically erratic and influenced by unknown circumstances.

Malkiel and Sharp realized that it was better for investors to invest in a well-diversified and passively managed fund because of the short-term randomness of returns. Theoretically, a monkey with blinders tossing darts at a newspaper’s financial sections might choose a portfolio that would perform equally well as one carefully selected by specialists, according to a contentious claim made in Malkiel’s work.

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Random walk theory in action

The Wall Street Journal launched the annual Wall Street Journal Dartboard Contest in 1988, in which professional investors competed with darts to determine who was the best stock picker. Wall Street Journal employees played the role of monkeys throwing darts. It is the most famous example of the use of random walk theory.

The Wall Street Journal revealed the outcomes of 140+ contests, showing that experts had triumphed in 87 of them while dart throwers were victorious in 55. Only 76 contests  saw the professionals succeed in outperforming the Dow Jones Industrial Average (DJIA). 

Malkiel remarked that the selections of the specialists profited from the increase in stock price brought on the publicity once stock experts issued a suggestion. Since specialists only could outperform the markets 50% of the time, according to supporters of passive management, it would have been best if the investors chose a passive fund with reduced management costs.

The bottom line 

The random walk theory suggests that the ideal way to proceed is to invest in a portfolio that duplicates the whole market of stocks because it is unachievable for investors to outperform average market performances over the long term.

However, an experiment conducted by the World Street Journal showed that professional investors who use technical and fundamental analysis are more likely to make correct predictions about the movement of stock prices than just a monkey with a dart.