Random Walk Theory (Stock Market) - Explained
What is the Random Walk Theory?
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Table of ContentsWhat is the Random Walk Theory?How Does the Random Walk Theory Work?
What is the Random Walk Theory?
The Random Walk Theory or Random Walk Hypothesis is a financial theory that states the prices of securities in a stock market are random and not influenced by past events. It suggests the price movement of the stocks cannot be predicted on the basis of its past movements or trend.
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How Does the Random Walk Theory Work?
The theory is named after the book A Random Walk Down Wall Street written by American economist Burton Malkiel. The theory argues the stock price movements are independent of one another and have the same probability distribution. It says the stocks prices take an unpredictable random path. According to this theory, it is impossible to outperform the market without taking an additional risk as the chances of a stocks future price going up is the same as the chances of it going down. This fluctuation cannot be predicted by looking into its past movement. The theory discards all the methods of predicting stock prices as a futile effort. However, the critics of this theory believe stocks maintain a price trend over time and one can outperform the market by carefully planning entry and exit points without assuming the risk. In his book Malkei argued it is a common misconception that the events are correlated as they come in cluster and streaks but the streaks occur in random data such as coin tosses. Malkeis theory argues the intrinsic value is undependable as it depends on subjective estimates of future earnings using different factors including expected growth rates, estimated risk, and interest rate. In his book Malkei stated, a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts." This comment attracted a lot of criticism from the finance experts in the U.S and outside. In 1988, the Wall Street Journal created the annual Wall Street Journal Dartboard contest to test this theory propagated by Malkei. In the contest, the staffs of the Wall Street Journal played the role of the dart-throwing monkeys and experts were invited to participate in the contest against the dart-throwing monkeys. The Wall Street Journal published the result of the contest after 100 rounds. It was seen the experts won in 61 round and the dart-throwers won 39 times. In the reaction, Malkei said when experts make a recommendation the stock enjoys publicity jump and that helped the experts to win the contest. Malkei and other proponents of this theory advocates for a long-term buy and hold strategy. According to them, it is the best practice for the investors to invest in a passively managed, well-diversified fund. That reduces the risk and involves much lower management fees. Although many investors still hold that Malkeis ideas were partially or completely true the investing experts argue the theory is redundant in present context. They are of the view that as now all the relevant news and up to date stocks quotes are available to every investor it is quite possible to plan a well-devised investment strategy without taking much risks.