RANDOM WALK THEORY



The random walk theory, in its simplest form, states that stock prices follow no predictable pattern. A controversial proposition, the theory, when taken to its extreme, counters the many forms of security analysis—including fundamental and technical analysis —that purport to positively identify price and risk trends.

The notion of a "random walk" is a mathematical concept for a variable, in this case share price, whose future values are unrelated to those past. The idea has been applied to many financial and nonfinancial phenomena, but in the business world it is most associated with scholarship on stock prices that began in the 1950s and climaxed in the 1970s.

During that period, a number of academic studies were advanced to describe an observed randomness in stock prices. Important contributions included Maurice Kendall's 1953 article "The Analysis of Economic Time Series," published in the Journal of the Royal Statistical Society, and the 1964 book The Random Character of Stock Market Prices by Paul H. Cootner. But the theory's application to stock market pricing is perhaps best associated with Princeton economist Burton G. Malkiel's 1973 classic A Random Walk Down Wall Street.

The theory is seemingly borne out by a casual comparison of how highly managed mutual funds or other professionally selected stock portfolios regularly underperform the market as a whole. Consequently, random walk proponents recommended wide diversification to mirror the entire market's breadth, such as by choosing stocks based on indexes like the Standard & Poor's 500 or, more recently, the Wilshire 5000.

The theory is deeply intertwined with the efficient market theory, which holds that markets are constantly and immediately correcting prices based on new information. When markets are efficient, the theory posits, no stock is undervalued or overvalued at a particular moment, and once information becomes available that a stock may not be priced accurately in relation to the company's performance or growth prospects, the markets quickly correct that condition. Both theories were greeted with skepticism early on, but quickly grew to exert influence on both academics and professionals.

However, even as Malkiel and like-minded analysts continued to carry the random walk banner in the 1990s, since the 1970s there has been mounting evidence that stock prices aren't entirely random and markets aren't perfectly efficient. Large studies on U.S. and international stock data have suggested that technical price indicators such as moving averages are indeed positively correlated with accurate predictions of future price movements. Thus, critics of the random walk theory conclude that studies showing random walk tendencies were unsophisticated or failed to ask the right questions about price patterns.

Opponents to random walk point out the inefficiencies of the market that make it possible, as they see it, to anticipate with better than random accuracy what a stock might do under certain circumstances. These inefficiencies include incomplete or even conflicting information about companies as well as the market's propensity to under- and overreact to different types of new information.

Nonetheless, because many aspects of price movements remain ambiguous, the general tenets of the random walk theory continue to hold sway with many stock analysts and economists, and will continue to fuel new research and debate for the foreseeable future.

FURTHER READING:

Brock, William, Josef Lakonishok, and Blake LeBaron. "Simple Technical Trading Rules and the Stochastic Properties of Stock Returns." Journal of Finance, December 1992.

Hulbert, Mark. "A Random Walk Down Wall Street." Forbes, 21 October 1996.

Koretz, Gene. "A Less-Than-Random Walk." Business Week, 21 December 1998.

Lo, Andrew W., and Archie Craig MacKinlay. A Non-Random Walk Down Wall Street. Princeton, NJ: Princeton University Press, 1999.

Musgrave, Gerald L. "A Random Walk Down Wall Street." Business Economics, April 1997.



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