Random Walk Theory

RAVI

Random Walks in
Stock- Market Prices
FOR MANY YEARS economists,
statisticians,
and teachers of finance have been
interested
in developing and testing models of
stock price behaviour.
One important model that has evolved
from this research is the theory of
random walks

This theory casts serious doubt on many other

methods for describing and predicting stock
price behavior- methods that have
considerable
popularity outside the academic world.
In general, the theory of random walks raises
challenging questions for anyone who
has more than a passing interest in
nderstanding
the behavior of stock prices.

Unfortunately, however, most

discussions of
the theory have appeared in technical
academic journals and in a form which
the non-mathematician would usually
find incomprehensible.
General terms, the two approaches
to predicting stock prices that are
commonly
espoused by market professionals.

(1) chartist or technical theories

and
(2) the theory of fundamental or intrinsic
value analysis
The basic assumption of all the chartist or
technical theories is that history tends to
repeat itself, that is, past patterns of price
behavior in individual securities will tend
to recur in the future.

Thus the way to predict stock prices (and, of course,

increase ones potential gains) is to develop a
familiarity with past patterns of price behavior in order
to recognize situations of likely recurrence.
The assumption of the fundamental analysis approach
is that at any point in time an individual security has an
intrinsic value (or, in the terms of the economist, an
equilibrium price) which depends on the earning
potential of the security.
The earning potential of the security depends in turn on
such fundamental factors as quality of management,
outlook for the industry and the economy, etc.

Through a careful study of these

fundamental
factors the analyst should, in principle,
be able to determine whether the
actual price of a security is above or
below its intrinsic value.

Theory of Random Walks

Introduction
Chartist theories and the theory of
fundamental analysis are really the
province of the market professional
and, to a large extent, of teachers of
finance.
Random-walk theorists usually start
from
the premise that the major security
exchanges
are good examples of efficient

Efficient Market
An efficient market is defined as a
market where there are large
numbers of rational profitmaximizers actively competing, with
each trying to predict future market
values of individual securities, and
where important current information
is almost freely available to all
participants.

In an efficient market, competition among

the many intelligent participants leads to a
situation where, at any point in time, actual
prices of individual securities already reflect
the effects of information based both
on events that have already occurred and
on events which as of now the market
expects
to take place in the future.

 In other words, in an efficient market at any point in

time the actual price of a security will be a good
estimate of its intrinsic value.
New Information :
The new information may involve such things as the
success of a current research and development project,
a change in management, a tariff imposed on the
industrys
product by a foreign country, an increase in industrial
production, or any other actual or anticipated change
in a factor which is likely to affect the companys
prospects.

Random Walk Theory

The theory that stock price changes have
the same distribution and are independent
of each other, so the past movement or
trend of a stock price or market cannot be
used to predict its future movement.
In short, random walk says that stocks take
a random and unpredictable path.
Under the random walk theory, there is an
equal chance that a stock's price will either
rise or fall from current levels.

Random Walk Theory

While EMT suggests that stock is
always efficiently priced this theory
suggests that price behavior is never
based on anything predictable, but is
completely random.
The random walk theory is the belief
that price behavior cannot be
predicted because it does not act on
any predictive fundamental or
technical indicators.

Background of Random Walk Theory

Random walk theory gained popularity in
1973 when Burton Malkiel wrote "A Random
Walk Down Wall Street", a book that is now
regarded as an investment classic.
Originally examined by Maurice Kendall in
1953, the theory states that stock price
fluctuations are independent of each other
and have the same probability distribution,
but that over a period of time, prices
maintain an upward trend.

Background of Random Walk Theory

random walk hypothesis, 1st
espoused by French mathematician
Louis Bachelier in 1900, which states
that stock prices are random, like the
steps taken by a drunk, and therefore
are unpredictable.
A few studies appeared in the
1930s, but the random walk
hypothesis was studied and debated
intensively in the 1960s

Random Walk Theory Explained

Chartists and technical theorists believe
historical patterns can be used to project
future prices. While the random walk
hypothesis claims that such movements
cannot be accurately predicted.
I'll start by comparing random walk to
other popular theories such as the
efficient market hypothesis, fundamental
analysis, and technical analysis.

Random Walk and Competing Theories

Generally, there are two competing approaches to
predicting the movements of stocks: fundamental and
technical analysis.
Fundamental Theorists
o believe the price of a stock is a function of its intrinsic
value, which depends heavily on the future earnings
potential for a company.
o factors such as industry trends, economic news, Global
news and the company's earnings per share outlook,
fundamental analyst can determine if the stock's price
is above or below its intrinsic value.
o Comparing a stock's price to its intrinsic value allows
the fundamental analyst to predict the potential future
direction of the stock's price.

Technical Theorists
o believe that historical movements of a
stock's price can be used to predict
future price direction.
o Using methods such as charting, the
technical analyst will examine the
sequence of upward and downward
movements for a stock.
o These patterns of movements allow the
technical theorist to chart what they
believe will be future movements for the
stocks they are examining.

Random Walk and Efficient Market

Theorists
EMH states that financial markets are
efficient and that prices already reflect
all known information concerning a
stock or other security and that prices
rapidly adjust to any new information.
Information includes not only what is
currently known about a stock, but
also any future expectations, such as
earnings or dividend payments.

Random Walk and Efficient Market

Theorists
It seeks to explain the random walk hypothesis
by positing that only new information will
move stock prices significantly, and since new
information is presently unknown and occurs
at random, future movements in stock prices
are also unknown and, thus, move randomly.
Hence, it is not possible to outperform the
market by picking undervalued stocks, since
the efficient market hypothesis posits that
there are no undervalued or even overvalued
stocks.

Contradiction of Random Walk

Theory
While many still follow the preaching of Malkiel,
others believe that the investing landscape is
very different than it was when Malkiel wrote his
book nearly 30 years ago.
Today, everyone has easy and fast access to
relevant news and stock quotes. Investing is no
longer a game for the privileged.
Random walk has never been a popular concept
with those on Wall Street, probably because it
condemns the concepts on which it is based
such as analysis and stock picking.

Contradiction of Random Walk

Theory
The problem with the random walk theory is that it ignores
the easily observed trends and momentum factors that do
directly affect price movement.
Professors Andrew W. Lo and Archie Craig MacKinley (1999,
A Non-Random Walk Down Wall Street), a series of tests
demonstrated that at least some degree of predictability is
present in stocks based on a comparison between price
behavior and other influences (earnings, for example).
The same authors wrote a paper (2005, 'The Adaptive
Market Hypothesis') in which financial activity (price
behavior) is influenced not randomly, but by the same
factors affecting evolution (competition, adaptation, and
natural selection).

Practical Implications
The random walk hypothesis has some
practical implications to investors.
For example, since the short term
movement of a stock is random,
there is no sense in worrying about
timing the market. A buy and hold
strategy will be just as effective as
any attempt to time the purchase
and sale of securities.

Practical Implications
When investors buy stocks, they usually do
so because they believe the stock is worth
more than they are paying.
In the same way, investors sell stocks when
they believe the stock is worth less than
the selling price.
If the efficient market theory and random
walk hypothesis are true, then an investor's
ability to outperform the stock market is
more luck than analytical skill.