What is the Random Walk Theory….

Random walk theory or as it is often called – the efficient market hypothesis, signifies that stock price changes have the same distribution and are independent of each other. In short, market and securities prices are random and not influenced by past events.

A “Random walk” is a statistical trend in which a variable follows absolutely no discernible trend and moves relatively at random. The random walk theory as applied to trading, most clearly presented by Burton G. Malkiel, an economics professor at Princeton University and writer of A Random Walk Down Wall Street, posits that the price of securities moves randomly (hence the name of the theory), and that, therefore, any attempt to predict future price movement, either through fundamental or technical analysis, is ineffective.

What a random walk is

As outlined by the Random Walk Theory, neither technical analysis, which is the study of past stock prices in an attempt to estimate future prices, nor fundamental analysis, which is a study of the overall financial health of the economy, industry and the business of the company, would enable an investor to beat the market.

In finance, the hypothesis assumes that financial markets stock price changes are the random events.

There are two types of random walk theory. In both forms, the rapid incorporation of information is disadvantageous for traders and analysts. The semi-strong form states that public information is not going to assist any investor or analyst select undervalued securities because the market has already incorporated the information into the stock price. The strong form states that no information, public or private, will benefit an investor or analyst because even inside information is reflected in the current stock price.

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

Practical Implications

The random walk hypothesis has some practical implications for investors. For example, since the short-term movement of a stock is random, there is no sense in stressing 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.

When traders 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.

Conclusion

Random Walk Hypothesis says nothing of the reasons for price movements or the valuation of stocks. It does not depend on perfect market conditions or perfect market absorption of all information. What this Model postulates on the basis of empirical tests is that successive price changes are independent of the past changes. That means by implication that prices will average out and reflect the intrinsic value of a security.

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

If you believe in the random walk theory, then you should just invest in a good ETF or mutual fund designed to mirror the performance of the S&P 500 Index and hope for an overall bull market. If, on the other hand, you really believe that price movements are not random, then you should be polishing your fundamental and/or technical analysis skills, confident that doing such work will pay off with superior profits through actively trading the market.

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