What Is Random Walk Theory?

What Is Random Walk Theory?

You might have heard that stock prices are unpredictable, and that's exactly what random walk theory is all about. It suggests that changes in asset prices happen randomly, so stock prices move in ways you can't forecast. This theory also ties into the idea that the stock market is efficient, meaning it already reflects all the information out there.

A random walk directly challenges the notion that you can time the market or use technical analysis to spot patterns and make profits from trends in stock prices. I've seen it criticized by traders and analysts who insist that you can predict prices with methods like technical analysis.

Understanding Random Walk Theory

Economists have long argued that asset prices are basically random and unpredictable, with past price action having little or no influence on what's coming next. This is a core assumption of the efficient market hypothesis (EMH). Random walk theory builds on that, stating that stock prices reflect all available information and adjust quickly to anything new, so you can't really act on it to gain an edge.

This theory got popularized by economist Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. Malkiel's ideas align with the semi-strong form of the efficient market hypothesis, which says you can't consistently outperform the market. So, for you as an investor, this means the best long-term strategy might just be buying and holding a diversified portfolio.

Malkiel argues that trying to time or beat the market, or using fundamental or technical analysis to predict prices, is a waste of your time and can lead to underperformance. Instead, I recommend you consider buying and holding a broad index fund. While the theory has critics who think there are ways to predict and outperform using various techniques, it remains widely accepted in financial economics. By accepting that prices are unpredictable and markets are efficient, you can focus on long-term planning and avoid rash decisions based on short-term movements.

Important Reminder

Random walk theory reminds you of the importance of staying disciplined, patient, and focused on your long-term investment goals.

Criticisms of Random Walk Theory

The main criticism you'll hear is that random walk theory oversimplifies the complexity of financial markets, ignoring how market participants' behavior and actions affect prices and outcomes. Prices can be swayed by non-random factors like changes in interest rates, government regulations, or even unethical practices such as insider trading and market manipulation.

Market technicians argue that historical patterns and trends can give you useful info about future prices, directly challenging the theory's claim that past prices aren't informative. Other investors point to successful stock pickers like Warren Buffett, who have consistently outperformed the market over long periods by examining company fundamentals closely.

Another critique is that the theory assumes all investors have the same information, but in reality, big institutional investors often have access to more and better info than you do. Real-world markets show information asymmetries that make them inefficient.

Benoit Mandelbrot, a mathematician, criticized the theory by arguing that stock prices aren't random and don't follow a normal distribution—key assumptions of random walks. He noted that prices show long-term dependence and are better modeled by fractal geometry, so you should consider risks from extreme events like black swans. His ideas helped develop chaos theory in finance.

Dow Theory: A Non-Random Walk

Dow Theory stands as a competing idea to random walk. It includes tenets like stock prices moving in trends with distinct phases such as accumulation, markup, and distribution, and that volume indicates trend strength. Developed by Charles Dow in the late 19th century, this theory holds that you can analyze stock prices to predict future movements based on current trends.

Dow Theory clashes with random walk theory, which says prices are unpredictable and you can't consistently outperform the market. While Dow Theory acknowledges short-term random fluctuations, it argues that long-run prices reflect underlying economic trends, which you can identify through technical analysis.

Random Walk Theory in Action

A real-world example came in 1988 with The Wall Street Journal's Dartboard Contest, testing Malkiel’s theory. It pitted professional investors against random dart throws for picking stocks, with Journal staff acting as the dart throwers.

After over 140 contests, the results showed experts winning 87 and dart throwers 55. But experts only beat the Dow Jones Industrial Average in 76 contests. Malkiel noted that experts' picks got a publicity boost in stock prices from recommendations. Proponents of passive management say you'd be better off in a low-fee passive fund since experts only beat the market half the time.

Does Random Walk Theory Suggest That It’s Impossible to Make Money in Stocks?

No. The theory says it's impossible to consistently outperform the market long-term through picking stocks or timing, but you can still profit by buying and holding a diversified portfolio, like an index fund.

Does Random Walk Theory Apply Only to Stocks?

No. It's most common in stocks, but you can apply it to bonds, forex, and commodities markets too.

Is Random Walk Theory Correct?

It's debated among economists and practitioners. Some agree with its basics, but others challenge its assumptions and propose alternatives. Instances like bubbles or flash crashes show prices driven by emotions rather than randomness.

The Bottom Line

Random walk theory claims stock prices move randomly, uninfluenced by history, so you can't use past action or fundamental analysis to predict trends. If markets are random, they're efficient and reflect all info. The theory is popular among economists but criticized by technical and fundamental traders for being too simplistic and ignoring real outperformance by some.