Random Walk Theory – What It Is, Its Assumptions, and Implications

Random Walk Theory - What It Is, Its Assumptions, and Implications

Imagine you are standing at the edge of a vast, open field.

In front of you, there are hundreds of birds flying in different directions. Some are soaring high in the sky, while others are flying low to the ground. You watch as they flutter and flit about, seemingly without purpose or direction.

This scene is a lot like the random walk theory. It is a well-known concept used in finance to describe the unpredictable nature of the stock market.

The theory suggests that, just like the birds in the field, stock prices seem to move without any clear pattern or direction.

Now, you might think, is it so? Well, we will try to find out if that’s the case in this article.

What Is the Random Walk Theory?

Before getting into the theory, let’s understand what a “random walk” is.

A random walk is a statistical phenomenon in which a stock price follows no apparent trend and moves seemingly in an arbitrary manner. Now coming to the theory, it’s a mathematical model claiming that stocks‘ prices evolve according to a random walk.

Simply put, as per the theory, share prices move randomly; therefore, any attempt to predict future price movements through fundamental or technical analysis is futile. Stock prices are influenced by multiple factors, such as economic conditions, company performance, and investor sentiments. These factors can change rapidly and unexpectedly, making it nearly impossible to predict how a stock will behave in the short term.

But despite its unpredictable nature, the random walk theory does suggest that stock prices will tend to move upward over the long term as companies grow and prosper. It may be difficult to predict the next flutter or dip in the market. But investors who stay the course and keep a long-term perspective will ultimately be rewarded.

How Does the Random Walk Theory Work?

According to the random walk theory, the past movement or existing stock price trend cannot be used to predict its future direction (either upward or downward).

Thus, the core message is that it’s impossible to beat the market consistently, so investment advisors add little or no value to an investor’s portfolio.

Moreover, this theory questions the validity of using technical and fundamental analysis to trade or pick stocks for investing.

  • It considers fundamental analysis undependable because of the low quality of data available and its potential to get manipulated.
  • Likewise, it considers technical analysis unreliable because it results in the individuals following the charts and trading stock only ‘after’ a move has occurred. Most of the technical indicators are lagging in nature.

Random walk theory is a practical tool and has proven correct in many cases. Thus, it suggests people not waste money hiring fund managers to handle their portfolios. If some fund managers could provide better returns than the broader market, it could be due to luck, and it’s tough to sustain in the long run.

Basic Assumptions of Random Walk Theory

To be a viable theory, it must be based on evidence and be able to be tested through experimentation or other means of observation. However, observing or trying every aspect of a phenomenon is impossible, so people make assumptions when developing a theory. These assumptions are necessary to simplify the problem and make it more testable.

Below are the assumptions behind the development of the random walk theory.

1. Security price

The theory assumes that the security prices in the stock market follow a random walk.

2. Relationship among securities

It also assumes that the movement in the price of one security is independent of another.

3. Efficient market theory

Random walk theory aligns with the efficient market theory (EMT) to some extent. Though the rationale behind these theories is different, both agree that investors can’t outperform the broader market.

The core argument of EMT is that markets are efficient as the stock prices reflect all available information. Thus, investors don’t have any undue advantage over the market. Therefore, investing in Index funds or Exchange Traded Funds (ETFs) is the only way to earn a return in such markets.

Implications of Random Walk Theory

Below are some of the critical implications of the random walk theory.

  • The theory claims stock prices are not dependent on historical data points but only reflect the current information.
  • Technical or fundamental analysis doesn’t help predict the stock price due to its random nature.
  • Stock prices are independent, as the price of one stock does not influence others.
  • As stock prices are random, investors should buy index funds or ETFs instead of spending money on fund managers or involving in active investment.

Pros and Cons of Random Walk Theory

It is common for a phenomenon or a concept to have both pros and cons. The random walk theory is no exception to this rule.

Below are the notable advantages and disadvantages of this theory.

Advantages

1. Passive investing

The random walk theory suggests a cost-effective way of investing. It recommends investing in ETFs or index funds instead of hiring fund managers who will charge exorbitant commissions.

2. Evidence of randomness

Historical data shows that the stock market has not strictly followed the predicted pattern, proving that stock prices are indeed random.

Disadvantages

1. Markets are not entirely efficient

In reality, not all have the same information, and not at the same time. Insiders and industry titans can get better insights than retail investors and much earlier, which can give them an edge over others.

There are several instances where stock prices have shown to maintain a trend across the years.

3. Impact of information over price

A piece of news can affect the price of a stock for several days or even months. It contradicts the claim that prices react randomly.

A Non-Random Walk and Its Theories

Even the best theories have their cynics coming up with counterarguments. It also applies to the random walk theory. 

According to this theory, anyone can only beat the overall market average by chance or luck.

But, the advocates of technical analysis believe that a stock’s future price movements can be predicted based on patterns, trends, and historical price action. This concept is called the “Non-random walk.”

It implies that individuals with superior trading or investing skills can outperform the overall market average returns. This is totally against the basic premise of the random walk theory.

One fact that works in favor of the non-random walk is that there are fund houses and investors who consistently outperform the market average for long periods.

Let’s take Berkshire Hathaway, an American conglomerate, as an example. It has witnessed a 613% return on capital over the past 20 years. This is much higher than the S&P 500 index, which has a return of just 190% (excluding dividends).

Arguments Against the Random Walk Theory

One of the major criticisms of this theory comes from its underlying assumptions.

This theory advocates that passive investing is better as there are no trends in the market to follow actively. But if you ask an experienced and savvy investor, they would claim otherwise. They would be able to observe trends in stock prices and strategically buy stocks when the price is low and sell when the price is high, making profits in the process.

The random walk theory has also been applied to study cryptocurrencies, such as Bitcoin (BTC). Overall, the evidence for the random walk theory in the context of crypto prices is ‘mixed.’ The movement of these prices is likely influenced by a combination of randomness and more predictable factors.

Conclusion

The random walk theory reminds us that the world is complex and that we should be open to the possibility that things may not always unfold as we expect. It encourages us to embrace uncertainty and to be mindful of the role that chance plays in shaping our lives and the world around us.

But we can’t ignore the fact that this theory has its limitations. Its underlying assumption of markets being efficient is not entirely agreeable. Also, there are noticeable trends in the financial markets that investors take advantage from time to time. It implies that 100% randomness may not be a valid claim.

Thus, we can conclude that randomness is one of the important parameters influencing price movements but not the only factor.

FAQs

1. Why is random walk unpredictable?

Random walk theory prides itself on the fact that the stock prices are entirely unexpected and do not follow any trend or pattern. It means that future prices cannot be predicted based on past data points.

2. What makes the random walk theory different from the technical analysis?

Technical analysis helps identify patterns and trends from historical data points like price and volume. Based on these inputs, traders can determine if a trade can be initiated or not.

But, the random walk theory states that security price movements are random and unpredictable. Thus no one can figure out the future trends.

3. Do stock prices follow a random walk?

Well, this is open to interpretation. If you believe in the random walk theory, then yes, stock prices do follow a random walk.

But, there are several instances when stock prices show clear patterns and trends over long periods. For example, news like business growth or product launch can instantly boost the stock price.

Of course, the stock prices are chaotic and volatile, but we need more evidence to say it’s completely random.

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