Random-walk theory

The premise of the random-walk theory is that the STOCK MARKET’s past movement cannot predict its future movement. The direction that a stock price will take cannot be determined by its past price history. In other words, the rise and fall of the stock market is completely random, so it is impossible to outperform the market on a consistent basis by predicting how it will perform. The theory also contends that although stocks move up and down in a completely random manner, they will maintain an upward trend over time. The French mathematician Louis Bachelier (1870–1946) presented the random-walk theory in his dissertation “Theorie de la Spéculation” in 1890. In this work he talked about the random walk of financial market prices, among other topics. The term random walk derived from his analogy that trying to forecast market prices was like trying to predict the meandering steps of a drunkard. Unfortunately for Bachelier, his professors and colleagues did not support his ideas; he received a poor grade on his dissertation, was subsequently blackballed, and eventually dropped out of sight. He ended his days at an undistinguished teaching post in Besancon, and very little more is known of his life or his work. In 1953 statistician Maurice Kendall reexamined the random-walk theory, and in 1973 it gained great popularity with the publication of Burton Malkiel’s book A Random Walk Down Wall Street, which has gone through many subsequent editions. Today the basic idea of the random-walk theory is that the stock market is so efficient (information being dispersed so rapidly in the modern technology age) that it is impossible for anyone to take advantage of the information quickly enough to successfully buy and sell stocks without fear of losses. Trying to forecast the ups and downs of a stock is futile, because stocks have no regular pattern. In order to outperform or to at least try to outperform the market, one must be prepared to assume additional RISK. Malkiel, in fact, believes that a buy-and-hold strategy is statistically the best ways to go, as history has shown. The random-walk theory has never been particularly popular on WALL STREET, because it promotes the belief that one cannot predict the rise and fall of the stock market and which stocks to choose, making it difficult for the financiers on Wall Street to capitalize on their INVESTMENT knowledge with the investing public. Wall Street’s specialty is MONEY management and strategy, which is the opposite of the random-walk theory’s posture. Today investment information is widely available to the general public, who now can do their own investing online without hiring professional investors to help them. If the public takes to heart the random-walk theory and its belief that it is difficult if not impossible to accurately predict a stock’s path, they will likely have no need or desire for investing professionals at all. There are three different versions of the random-walk theory, which is considered a major component of the EFFICIENT MARKET THEORY. The first is the “weak” version, a rather bare-bones theory that future stock or market prices cannot be predicted from past stock or market prices only. The “semi-strong” version promotes the idea that even by using all publicly available information (e.g., ANNUAL REPORTs, analyst reports) one still cannot predict future stock prices. This theory says that this published information has already been factored into a stock price, which leaves no surprise element. The third version is the “strong,” which states that even insider knowledge of a stock will not help predict that stock’s future price. Given today’s efficient high-speed technology, the “strong” version holds that the stock market already knows everything there is to know, so the investor can never hold an advantage. Not all experts believe that these three versions are entirely accurate. Many do believe in the market’s efficiency but also think there are some inefficiencies that may perhaps help the investor get an occasional advantage. For example, because market analysts do not always follow smaller firms, this information is sometimes not factored into their open-market prices. This means that the market is not really 100-percent accurate and opens the door to some investment opportunities. The strong-market theory is also diminished somewhat by the work of questionable individuals who gain insider information and throw the market somewhat off course. There is another theory that views the markets as efficient but predictable. Andrew Lo, a professor of finance at the Sloan School of Management at the Massachusetts Institute of Technology, has published a book, A Non- Random Walk Down Wall Street, (2001) that goes against many of Burton Malkiel’s theories. Lo believes that it is possible to outperform the markets to some degree if one is willing to commit the time to financial research and the money to current technology. As it happens, most in the academic world do support the random-walk theory, but as the investment world for professionals and nonprofessionals becomes more technological and as more information becomes freely available, it is difficult to say how the theory will hold up in the coming years. With increasingly advanced financial tools, perhaps it is possible that investment predictions will become more accurate, but on the other hand, the market will have the same (if not even more advanced) tools, which would keep the market that one step ahead necessary to keep the random-walk theory vital.