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.
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.
Basic Assumption
The random walk theory assumes that the price of each security in the stock market follow a random walk.
The random walk theory also assumes that movement in the price of one security is independent of the movement in the price of another security.
History of the random walk theory
In 1863, a French mathematician turned stock Jules Ragnault published a book titled “The study of chance and the philosophy of exchange”.
Regnault’s work is considered one of the first attempts at the use of advanced mathematics in the analysis of the stock market.
Influenced by regnaults work , Louis Bachelier another French mathematician published a paper titled “Theory of speculation”.
This paper is credited with establishing the ground rules that would be key to the use of mathematics and statistics in the stock market.
In 1964, American financial economist Paul Coother published a book entitled “ The random character of stock market price” considered a classic text in the field of financial economics it inspired other works such as “ a random walk down wall street” by Buston Malkiel and “ random walks in stock market prices” by Eugene Farma.
Implication of the random walk theory
The random walk theory posits that it is impossible to predict the movement of stock prices , it is also impossible for a stock market investor to outperform or “beat” the market in the long run
This implies that it is impossible for an investor to outperform the market without taking on large amount of additional risk .
As such, the best strategy available to an investor is to invest in the market portfolio , for example, a portfolio that bears a resemblance to the total stock market and whose price reflects perfectly the movement of the prices of every security in the market.
Criticism of the random walk theory
One of the main criticism of the random walk theory is that the stock market consists of a large number of investors and the amount of time each investor spends in the market is different.
Thus, it is possible for trends to emerge in the prices of securities in the short run.
such other critics argue that the entire basis of the random walk theory is flawed and that stock prices do follow patterns or trends, even the long run.