What is Random Walk Theory?

By: Rupesh Oli

Random Walk Theory states that the movements of stock prices are random and unpredictable, hence the prediction cannot be made based on its past trends or movements. The terminology ‘Random Walk Theory’ is made popular by the professor, economist, and well-known mathematician Burton Malkiel in his book ‘A Random Walk Down Wall Street’ which was published in the year 1973. According to Malkiel, Random Walk Theory does prevail in an efficient market. It is because there is information available to investors in a fully transparent format in an efficient market. Hence, as the information is readily available to both buyers and sellers, they sell and buy the stocks according to it. The buyer and seller will react in the market based on their financial preferences and the information available to them. As a result, you cannot predict the movements of stocks.

The theory claims that the stock prices seen on a day-to-day basis are independent of each other and the analysis of past trends and patterns does not predict the future trend. It also states that the prediction of stock prices is useless in the long run. Malkiel pointed out intrinsic value, fundamental analysis, and technical analysis and went further through his justification that analysis done based on these three aspects is pointless to predict the future trend. Intrinsic value takes factors like dividend payouts, future growth rates, estimated interest rates, risks, etc. into consideration. Fundamental analysis involves analysis and interpretation of the published reports and available information of the particular company, industry analysis which could be easily misinterpreted, and the external factors outside the company and industry could affect and make the fundamental analysis irrelevant. Lastly, technical analysis is done based on the past trends of stocks, and the trader performs the action on the stock market, whether it be a buy or sell only after a certain trend is established. Hence, pointing out the flaws of the three analysis techniques, Malkiel claims all these three methods to predict future trends are flawed.

Hence, the assumptions made by Random Walk Theory can be summarized as: the price of each security in the stock market follows a random walk and the stock price of one security is independent of the stock price movement of another security in the market. The overall market cannot be outperformed without considering an additional risk to be taken. Those who tend to agree with this theory suggest a buy and hold strategy rather than constantly trading. Further, they recommend selecting the stocks that represent the overall market. Instead of selecting one or two stocks listed in S&P 500, it would be a wise idea to invest in the fund that represents the whole S&P 500. For instance, an ETF or index fund, in order to minimize your risk. The theory warns before hiring fund managers to manage your investment. It says that it is not a wise idea to waste money for hiring fund managers when the stock prices themselves are random and as the market is efficient, you have the information available to you, so why not grasp the information readily available to invest.

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Practical Testing of Random Walk Theory in Real Life

The random Theory test was put into test in 1988 through the Dart Throwing Investment Contest, well known to anyone who is keen on the world of investing. The contest was planned by the Wall Street Journal, in which professional investors and dummy investors were against each other in order to compete. Professional investors constituted of those who were working in the New York Stock Exchange (NYSE), whereas dummy investors comprised of Wall Street Journal Staff.

The experiment performed was entitled “The Wall Street Journal Dartboard Contest”. Dummy investors were given the task of throwing the dart for stock selection and professionals were picking up the stocks in a professional manner. Out of 100 contests, the dummy investors only won 39, whereas the remaining 61 were won by the professional ones. If we keep aside the total win of 61 for once, it was found that professionals were only able to beat Dow Jones Industrial Average (DIJA) in only 51 competitions out of 61 they have won.

History Reflecting Random Walk Theory

Many in the past have provided the concept of random walk theory to enthusiast investors on a time-to-time basis. French broker Jules Regnault mentioned the concept in his book published in 1863, then Louis Bachelier, a French mathematician provided some remarkable insights in his dissertation named “The Theory of Speculation” published in 1900. Later in 1964, Professor Paul Cootner presented the idea in his 1964 book entitled “The Random Character of Stock Prices”. Then finally, as stated above the term became popular when Burton Malkiel mentioned the theory in his 1973 book “A Random Walk Down Wall Street”. More to mention, the theory was also coined by Eugene Fama in his article and Maurice Kendall in his 1953 research paper.

Applicability of Random Walk Theory

So, how can Random Walk Theory be applied to stocks? When a theory gets introduced, it is obvious that there will be opponents criticizing the theory on one hand, and the proponents favoring the theory on other hand. Apart from criticism, one should gain meaningful insights and see its positive aspect, trying to analyze the theory from the perspective of proponents.

The stock movements are random and unpredictable as suggested by theory. It has loopholes for criticism as well but reflects truth to some extent. In accordance with theory, if the trend and stock movement would have been so easy to predict, then all the investors around the world would have made large chunks of money. No one would be losing, and everyone would be winning. Hence, speaking in favor of losers in the stock market, it raises the question “Why are people losing money?”, justifying its unpredictability terminology in the theory.

As further stated, the stock price is not dependent on the price that was seen in the market yesterday. It argues that stock price is reflected based on information available today and the price seen on yesterday’s market was based on yesterday’s information. So, everybody has access to information, and they decide the flow of the market. Insider trading is neglected in this theory which refines the theory to some extent. Although insider trading can be seen on Nepal and India’s stock markets, it is illegal on foreign country’s stock markets.

Criticism

If we take a look at Random Walk Theory from the perspective of opponents rather than the proponents, we can easily find out its flaws and those would be enough to have an overall glance at the theory from the criticism’s perception.

Critics of the theory argue based on two vital aspects, one “outperforming the market” and other “pattern or movement of stocks”. Random walk theory states that it is not possible to outperform the market and the patterns or movements the stock follows are not useful in predicting what’s arriving in the future time frame. This is where critics were exactly able to argue by expressing their opinions exactly opposite what the theory stated.

Firstly, they criticized the theory by arguing that it is possible to outperform the market through the devotion of time and effort in order to understand the market efficiently and by performing entry and exit at the market carefully. If done so, we have seen that savvy investors were able to beat the market return on various instances. It is because they follow the strategy of buying the stocks when the price is low and sell them at peak points, thus making a large chunk of profit in between. However, it is true that it does not apply to every investor. Some fail and some do succeed. That varies and the amount of study and research that an investor does regarding the market varies too.

Secondly, critics criticized the theory through their statement, stocks do follow certain patterns and trends. If a proper technical analysis is to be done, then the market is obviously able to generate profit. They further argue that it does not imply that the pattern does not exist if investors were not able to clearly identify the pattern. Maybe their analysis skills are lacking, suggesting them not enough accuracy in their possible trends that they were able to identify. Further various risk management strategies could be applied in order to minimize the risk if a certain pattern were identified like stop loss. The majority of cases have shown that stocks do follow a trend over a certain period. For instance, on a year-to-year basis, monthly basis, etc.

Contrary Viewpoint: A Way to Non-Random Walk

There is definitely a way for a non-random walk in the market. It is through acquiring enough knowledge of the market and delivering consistent effort and time to understand the market properly. Some of the factors can be considered in order to perform a non-random walk in the market, which is mentioned below.

Enrich yourself with enhanced market analysis and trading skills.
Make sure you possess strong fundamental and technical analysis skills in order to beat the market. Michael Steinhardt can be taken as a perfect example as he was able to generate double the return of the S&P 500 market index from 1967 to 1975, with a return of 24% over 28 years.
Divest your time as much as you can, to study the market on the regular basis. Try to analyze what is affecting the market when prices go up and down. A trader/investor with adequate knowledge is far better than someone who enters the market relying on someone else ‘tip’ or suggestion, in order to buy and sell. They might succeed in the short run; however, they are sure to decline in the long For them, enough knowledge of the market is required to deliver a consistent result in the market.

Some Research Paper Findings

This section will uncover two research papers, on which researchers have taken Random Walk Theory as their interest of research and came up with some significant results.

The first one is the research paper entitled ‘The Random Walk Theory: An Empirical Test in the Nigerian Capital Market’, published in a Journal named ‘Asian Economic and Financial Review’ in 2014 conducted by researcher Barine Michael. The research found out that stock price movements do not follow the random walk pattern in Nigerian Stock Exchange and hence, the random walk theory is not favored by the research conducted in the Nigerian capital market. Further, the Nigerian Stock Exchange seemed to follow a definite path. The fundamental analysis seemed to have largely affected it, as people were making a decision based on stock’s previous year information and fundamentals. For instance, dividend rate, equity capitalization rate, growth of dividends on a year-to-year basis, etc.

Moving on towards the second research paper entitled ‘The Random Walk Theory: An Empirical Test’ published in a journal named ‘Financial Analysts Journal’. The research was done by James C. van Horne and George G. C. Parker. What this research paper found out is exactly the opposite of the previous research. For the research, a random sample of 30 stocks was selected from the New York Stock Exchange. From January 1960 to June 1966, daily closing prices of the stocks were studied over a period of time. The research concluded that stock price changes are random and favored the Random Walk Theory. It concludes that a technical trader who performs his/her action in the market based on past stock patterns and price fluctuations does not realize that the profits and returns on buy-and-hold strategy are exceptionally higher than the constant trade. Since frequent transactions are made, the transaction fee/cost gets ignored during the process. Further, it supports the perception that no meaningful degree of dependence can be found on a series of stock price fluctuations over the period.

So, you might be wondering exactly how the second research justifies Random Walk Theory? If taken a look at the research paper deeply, it can be found that Random Walk Theory can be implied from another perspective. As the research paper mentions, the theory states that Technical Trading will not lead to significant or above-average return than a buy-and-hold strategy. This is what researchers exactly have justified in their paper. As stated above, traders are constantly trading and do not enjoy the power of compounding in the long run. Hence, an investor who adopts a buy-and-hold strategy generates more profit than the traders who seem to constantly trade.

Conclusion

To conclude, Random Walk Theory does provide some valuable insights to traders/investors. As a theory gets introduced, the one who introduces the theory must be ready to accept the criticisms from critics. However, as an investor, we can learn from its criticism as well because it makes the investor familiar with the lacking aspect of the theory. So, you could possibly act in two different ways, depending on whether you are in favor of the theory or not.

If you favor the theory and fall under one of the many proponents of the theory, you definitely agree that stock prices are random. Hence, it is wise to adopt a buy and hold strategy in order to gain good returns and minimize the risk you tend to take through constant trading, as you agree to the random nature of the stock as it fluctuates. Long-term holding does possess a higher success ratio and profit yield, as the theory suggested. Further, you could invest in the overall S&P market instead of just a minor number of stocks, as you will be representing the overall market and minimizing your loss tendency through diversification. For instance, investing in Index Fund or Exchange Traded Funds.

If you do not favor the theory or fall under the critics of the theory, you tend to agree that stock prices are not random and follow certain patterns or trends. If so, polish your market analysis skills. Make sure you possess solid fundamental and technical analysis skills, which are vital. If done so, you could nearly predict the upcoming pattern, if not accurate leading you to take the right action at the right point of time for better entry and exit yielding you the good profit in between.

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