How Can Random Walk Theory Be Applied to Investing?

The random walk theory maintains that individual stocks do not move in any discernible pattern and therefore their short-term future movements cannot be predicted in advance.

Since the market indexes overall tend to rise over the long-term, adherents of random walk theory would be likely to recommend investing in a passively-managed diversified index fund.

However, they reject out of hand the basic tenet of the investment management profession: That stock-picking is an art and a science that can lead to returns that exceed the market indexes.

Random walk theory is best represented by a contest regularly staged by The Wall Street Journal, in which professional stock pickers compete against investments selected by throwing darts at a stock table. The contest was held regularly for 14 years without conclusive results.

A new test has emerged in recent years, however. Highly sophisticated computer algorithms are being used to identify and exploit trends in stock prices. The trends they spot may last for fractions of a second but their existence, no matter how brief, would tend to overturn random walk theory.

Understanding Random Walk Theory

The theory and its name were popularized in a 1973 book, A Random Walk Down Wall Street, by Princeton economist Burton Malkiel. However, the concept was not new. In fact, it might be considered a third, and outlier, theory of stock-picking.

There are two main disciplines for professional stock pickers:

• Fundamental analysis attempts to pinpoint a stock’s intrinsic value by examining all financial data relevant to the company, its industry, and the economy as a whole.
• Technical analysis relies on historical price and volume data in an attempt to forecast the direction of a stock’s price movements.

Random walk theory concludes that both of these disciplines are fruitless attempts to impose order on chaos.

Fundamental and Technical Analysis

The goal of both fundamental analysis and technical analysis is to pick stocks that outperform a specific market index or other benchmark over time. Random walk theorists would argue that this adds risk without any likelihood of additional rewards.

• Fundamental analysts study all of the financial data related to a company and its industry in order to identify stocks that are in a position to outperform the market as a whole.
• Technical analysts study the patterns of trading activity in order to forecast trends, with the goal of pinpointing the correct time to buy and sell a stock in order to outperform the market as a whole.

Academics have not conclusively proved whether the stock market truly operates like a random walk or is based on predictable trends. There have been many published studies that support or undermine both sides of the issue.