Random Walk Theory

It is a financial theory that states that the stock prices in a stock market are independent of their historical trends.

Author: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Reviewed By: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:November 8, 2023

What Is Random Walk Theory?

Random walk theory or random walk hypothesis is a financial theory that states that the stock prices in a stock market are independent of their historical trends. This means that the prices of these securities follow an irregular trend.

The theory further states that the future prevailing prices of a stock cannot be predicted accurately even after deploying its historical prices. 

It all started with a mathematician, Jules Regnault, who turned into a stockbroker and wrote a book named “Calcul des Chances et Philosophie de la Bourse” or “The Study of Chance and the Philosophy of Exchange.” 

He pioneered the application of mathematics to the stock market for stock market analysis. Another French mathematician, Louis Bachelier, published his paper, “Théorie de la Spéculation,” or the “Theory of Speculation.” 

This theory has been named after the book “A Random Walk Down Wall Street,” authored by American economist Burton Malkiel

His theory about the stock market that the stock prices follow an unpredictable random path was mainly criticized by many experts in America alone and worldwide too. 

This theory works over the following two broad assumptions:

  1. The price of the securities on the stock market follows a random trend
  2. There is no dependency between any two securities being traded in the stock market

We will discuss in detail the criticism of the foundation built by these assumptions later in the coming sections.

An interesting point to note here is that Malkiel himself mentioned the term “efficient market” while delineating his theory that plays a crucial role.

He says that stock prices cannot be predicted through any analysis in a stock market as they follow a random path. 

Let’s delve into this a tad bit. 

An efficient market, by definition, is a market where all the information required for trading in the stock market is freely available; that is, the market is transparent, and all the players have equal access to general information about the stocks being traded in the market.

The definition here states that an efficient market allows a trader to analyze all the necessary information about the stock they plan to buy after proper strategic planning through the information available. 

Let us hold onto that thought and move to the next section. It’s going to be an interesting yet mind-boggling conversation! 

how does the Random Walk Theory work?

Although criticized by many stock analysts, Random Walk Theory has proven itself in the past. The most recent one was the outbreak of COVID-22, which was completely unanticipated and out of control. 

This theory states that if the stock prices are random, then the prediction of the future standing of the stock cannot be made. 

Fund managers are the people whom a company hires to perform predictive analyses of stock prices based on their recent historical records. 

Let us say that the managers’ forecasts work out, and the company earns a considerable profit. For this, there can be two explanations at large. 

First, the forecasting and analysis done by the experts were accurate enough to let the company earn that profit.

Second, it could be possible that the markets favored the company during that period, and the profits were bagged due to coincidence and luck. 

As for the first statement made in that respect, the question arises that if the predictions are positive, the company is more likely to get huge returns, then why is it so that even after rigorous research techniques and models, they end up earning just the face value or even lower?  

Furthermore, for the second statement, it could be that the market showed trends in favor of the company leading them to earn alpha returns. 

The random walk theory simply says that these profits are earned by nothing but chance, as the stock prices cannot be determined for the future. 

We are now coming back to our previous conversation on efficient markets. As we mentioned, an efficient market provides any information required for analyzing the stocks of a company. 

This implies that the future price of stocks can be predicted with the help of their historical movements and trends, given that the market is efficient. 

If this is true, why do some expert analysts bear losses and others do not?

This would only give one the impression that either loss or gain, it’s a matter of luck. 

However, experts disagree with this theory. In a world where a computer achieves the impossible, algorithms come in handy while trading. 

A strong algorithm will bear more fruits, and a weak one will bear more losses. 

Let’s take a real-time example to illustrate Random Walk Theory. 

We all recollect when COVID-19 hit the world economy, and the stock markets thrashed worldwide. This was a sudden happening and a factor that was out of everyone’s control.

Even the investors who have practicing investment for a long time and who knew their strategies and their way into and out of the market could not do anything but bear huge losses. 

This is one of those instances where no pre-planned strategy or a strong algorithm could improve one’s market standing in such adversities.

Pros And Criticisms Of Random Walk Theory

Since every theory has advantages and disadvantages, Random Walk Theory lists specific pros and cons to keep in mind.

A few of the pros and cons are:

Pros:

  • Markets are not entirely efficient. This means the information required to invest in that stock is not fully transparent.
  • Many insiders acquire information before the general public investors, giving them an edge over others. To overcome this catch, one should invest directly in ETFs (Exchange Traded Funds) to earn decent returns.
    ETFs are funds that hold multiple types of securities as their underlying asset. An ETF is an excellent option for a risk-averse person as it allows the option of portfolio diversification. You can read more about ETFs here
  • Moreover, historical trends depict that a stock price can easily fluctuate by even significantly irrelevant news about a company. Since sentiments can’t be predicted, the stock movements are unpredictable and erratic.
  • Random Walk Theory is gaining popularity among passive investors as the fund managers fail to outperform the index and increase the investors’ increasing belief in randomness. 

Critics:

  • Random Walk Theory argues that it is not entirely impossible to outperform the market. However, one can efficiently earn a decent amount of profits with careful analysis and possible future happenings related to that particular stock.
  • They further state that this theory is baseless and stocks instead follow a trend that could be deduced from historical data, combined with certain future possible factors that might affect the stock movement. 
  • There may be an infinite number of factors influencing the stock movement that might make the task of detecting the pattern pretty cumbersome. But this, they argue, doesn’t mean that if a pattern is not quickly visible, it doesn’t exist. 

Random walk theory in the stock market

It’s time to resume the conversation that we began in the first section. 

We’ve only talked about how this theory states that stock movements are unpredictable and that one cannot outperform the market index by any financial analysis. 

When we want to earn money quickly, we invest in stocks. Then, we wait for them to grow over time and pull back the profits. The rebuttal here is that if earning through investing in stocks is that easy, why do many investors end up losing their money? 

If Random Walk Theory doesn’t stand any chance in the practicality of stock markets, why are some investors able to bag profits from the same stock while other investors bear losses?

This is all about the timing and future growth probability of that particular company. The best profits are earned when the market is unstable and erratic. 

The investor needs to plan his standing in the market in such a strategic way that the market favors them. Moreover, RWT doesn’t consider the concept of insider information or an information edge which, in turn, refutes the fact that stocks are random. 

In essence, today’s stock price is independent of yesterday’s stock price, an aggregate result of information available at that time. Due to the failure of many fund managers to generate sufficient profits over stocks, there has been an increase in the number of investors in index funds.

Index funds are a kind of mutual fund or ETF that tracks the market value of a specified basket of underlying assets.

Click here to read more about Index Funds. All in all, trading is assumed between informed buyers and sellers with completely different strategies. Thus, ultimately the market follows a random path.

Conclusion

So, we have dwelled on the intricacies of this stock theory thus far. What do you think was a reasonable argument with respect to or against this theory? 

All these years, the debate over this theory has never had a hiatus among its fanatics and critics. Each individual depends mainly on how much investment has been put into the stock market. 

The only way to deal with this problem is to act according to what is best for you as an investor. For example, if you believe that stock movement is random, you should invest your money into ETFs, which reflect the whole market return in just one portfolio. 

ETFs, as told earlier, are more diverse as they constitute a mix of assets that yield better returns with minimal risk when blended into one single portfolio. Thus, this option could be used by risk-averse investors.

Now, if you are the other half, you think that stocks are not random but rather form a pattern through which one can predict future prices; you should perform financial analysis and generate return predictions for future periods for your investment.

After all, investing some of your wealth is better than investing nothing. 

You can also try our Valuation Modeling Course by clicking the banner below now!

Researched and authored by Anushka Raj Sonkar | LinkedIn

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