XYZ company’s stock price was ₹500 in January, but suddenly its price dipped to ₹350 in February due to unforeseen circumstances. Then, again in March, it changed to ₹450. Here stock prices are random, implying that it is impossible to forecast the price movement of stocks using their past trends or activities. So then, how can investors benefit from randomness? What are the advantages and limitations of randomness in the stock market?
In this article, let’s learn more about the financial concept that considers randomness.
What is Random Walk Theory?
To understand Random Walk Theory, you must first understand what a ‘Random Walk’ is. A ‘Random Walk’ in probability theory indicates random variables having an independent effect on processes, i.e., the randomness has no structure. For instance, a drunk person lacks a preference for direction. Therefore, he will move in all directions equally often.
The Random Walk Theory was introduced in 1973 by economist Burton Malkiel in his book “A Random Walk Down Wall Street.” As per this financial theory, stock market prices change in a way that is similar to a random walk. He compared stock prices and the uneven “steps of a drunk guy.”
According to the Random Walk Theory, there is no consistent orderly pattern, and the prices displayed in the stock market are decided by random events independent of the past.
This theory claims that it is impossible to outperform the market without assuming additional risk. It does not depend on technical or fundamental analysis, as technical analysts only buy or sell a security once a well-established trend has emerged, believing technical analysis to be unreliable. The theory also considers fundamental analysis unreliable due to the frequently substandard quality of data gathered and its susceptibility to misunderstanding.
Let’s understand this with an example. Consider a toy manufacturing company whose stock is trading at ₹200. Suddenly there was news of a fire accident in the factory, and the stock price fell by 20%. The next day when the market started, the stock price fell by another 10%. According to the Random Walk Theory, stock prices fell the day after a fire because of the news of the fire, but they didn’t decrease the next day because of more fire news which may be because of the loss depicted by the company. As a result, stock prices are independent of one another and do not depend on technical or fundamental analysis. Stocks have distinct reactions to several pieces of news every day.
Assumption of Random Walk Theory
Like any other theory, the Random Walk Theory is also based on a few assumptions. Some assumptions are as follows:
l According to the Random Walk Theory, each security’s price on the stock market moves randomly.
l It also assumes that price changes for one asset do not affect price changes for other securities.
What can you conclude from the Random Walk Theory?
Below mentioned are some of the derivations from this theory.
l Technical or fundamental analysis cannot be used to predict the market; hence it is impossible to foresee the stock price.
l Today’s stock price does not impact tomorrow’s stock price since stock prices are independent.
l The probability of a share price rising at any given period is the same as that of a share price falling.
l Random Walk Theory also contends that financial advisors don’t significantly improve an investor’s portfolio as the market is random.
Limitations of Random Walk Theory
Though this theory has many implications, there are a few limitations. According to the Random Walk Theory, the entry and exit points must be carefully considered to outperform the market, which takes time, effort, and expertise.
Of course, a certain amount of randomness in market behavior will always exist, but traders can reduce the risk of erratic fluctuations by using a risk management technique.
How can Random Walk Theory be applied to investing?
Due to huge randomness in the market, the theory claims that longer-term positions will have the most important probability of success, and theory proponents frequently adopt a purchase-and-hold approach. Exchange Traded Funds (ETFs) and indexes are popular tools of investing because they track various firms’ share values, and traders will seek to own a diversified selection of shares that best represents the entire stock market.
Conclusion
The Random Walk Theory states that the best course of action is to only invest in a portfolio that duplicates an infinite number of stocks because it is difficult for individuals to outperform market average performance over the long term. Believing taking on minimal risk is the only way to match market performance. Yet, this is for long-term changes in the market. The Random Walk Theory might not hold in the short run. This is supported by the fact that few traders can outperform the market averages over extended periods by seizing short-term irregularities in asset prices.
Disclaimer
- This blog is exclusively for educational purposes
- Investments in the securities market are subject to market risks; read all the related documents carefully before investing
