The Random Walk Theory, Explained
The random walk theory is a financial hypothesis that says that stock market prices evolve and change by a “random walk”, making stock prices unpredictable. According to the theory, because stock prices are on this unpredictable path, any given stock’s price is as likely to go up in the future as it is to go down.
Inherent Risk in Stock Investing
A person who subscribes to the random walk theory believes it is impossible to outperform the market without assuming significant risk. The theory claims that an investor who does outperform the market (using either technical analysis or fundamental analysis ) can attribute that success to luck. If you have enough stock market investors, some are bound to outperform the market, but most are likely to see losses. Many experts accept the wisdom behind the random walk hypothesis. These same experts assert that there is no proof to suggest that either technical or fundamental analysts can consistently outperform the market.
The Efficient Market Hypothesis
Many believe that the random walk theory is supported by the efficient market hypothesis (EMH). According to the EMH, stocks are always trading at their fair value which would make it impossible for investors to either purchase undervalued stocks or sell stocks at a price greater than their value. It follows, then, that it should be impossible to outperform the overall market through careful stock selection or by timing the market. The only way an investor could obtain higher returns would be by purchasing riskier investments.
Arguments Against the Random Walk Theory
Fundamental investors and others who would dispute EMH point to the irrational behavior of investors in the later stages of a bull market and during times when the market is over-sold. In both cases, the market is driven by buyers in observance of the overall market, rather than the underlying value of any particular security. In fact, successful value investors (like Warren Buffett) make a good living by finding and exploiting opportunities where stocks are being traded below (often well below) their true of “intrinsic” value.
Good article on the random walk theory
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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