What Is Random Walk Theory?

The "random walk theory" is the belief in finance that a security's current market price is a product of chance rather than the sum of past events or the result of patterns in human behaviour.

Since its inception, the random walk theory has been a hotly debated topic among academics, investors and financial analysts from opposing viewpoints. Proponents support the idea that markets operate efficiently and believe the notion of a security having an "intrinsic value" to be false. In addition, supporters see the individual price movements of an actively traded security to be random, thereby making any attempt to forecast future pricing fluctuations an exercise in futility.

Conversely, opponents claim that it is indeed possible to gain insight concerning the future price of a security. Through the study of past pricing data and current market information, random walk challengers aim to identify and capitalise upon a specific security's value within the marketplace. Disciplines such as traditional fundamental analysis, as well as technical analysis, are often cited by random walk detractors as relevant methods of forecasting a security's future price.

Evolution Of The Random Walk Theory

Origins of the random walk financial theory can be traced to the year 1900 and French mathematician Louis Bachelier's paper "The Theory of Speculation."[1] Contrary to the accepted academic opinions of the time, Bachelier made the case that stock prices are independent of one another, and that past pricing data has no relevance upon the future price of a stock.

According to Bachelier, stock prices represent the "steps of a drunkard," with the next step being wildly unpredictable in comparison to the previous one. He asserted that consistent financial gain from stock picking was a negative expectation proposition, with the end result being "zero minus costs."

Bachelier's work on the subject sat dormant until the 1960s when the "efficient market hypothesis" (EMH) gained foothold in the world of finance. The hypothesis first gained popularity following the Ph.d dissertation of Eugene Fama in 1965, and it serves as a key tenet of modern random walk theory.[2] According to EMH, the current market price of a security reflects all available information and is its "true" value. This concept is important in relation to random walk theory; if current market price is a complete representation of the real value of a security, then no manner of analysis can provide insight into where price will move in the future.

Debate sparked by the presentation of EMH set the stage for a resurgence of ideas based upon random walk and its application to the modern marketplace. In 1973, Princeton economics professor Burton G. Malkiel's book, A Random Walk Down Wall Street, became a bestseller and is largely credited with bringing random walk theory to the forefront of modern economics.[3]

Malkiel expands upon the concept of random walk and EMH to present an argument that the active trading of stocks is a losing proposition due to transaction costs and the random nature of price movements. Investment strategies using various stock market indices and buy-and-hold trade management philosophies are deemed by Malkiel to be far superior to short-term trading strategies based upon technical analysis. As he stated, "Buy only companies that are expected to have above-average earnings growth over the next five years."[4]

Reaching A Consensus: Studies In Random Walk

Over the years, the random walk theory has undergone extensive scrutiny. Many scientifically conducted studies and informal trials have been performed in an attempt to illustrate its significance.

Comparisons drawn between the real-world performance of market professionals and experiments involving everything from dart-throwers to stock-picking primates have been used to quantify the random nature of markets.[5] Results of these studies seem to favour the random walk supporters, while detractors question both the validity of the studies and their results.

However, there is enough evidence that runs contrary to random walk theory to continue the debate. Financial products traded on emerging markets, futures markets or foreign currency markets have shown to deviate from randomness and provide an investor the opportunity to outperform the market. One area of research that has become popular in recent years concerns the price behaviour of listings on smaller, emerging equities markets.[6]

Summary

The random walk theory has been a hotly debated topic from its inception. Market professionals argue that markets do not necessarily operate in an efficient manner, and that price pattern recognition via the employment of technical analysis is a worthwhile endeavour. Contrarily, many academics and proponents of buy-and-hold investment strategies believe randomness to be the only truth in the marketplace.

Persuasive arguments can be made on both sides, but ultimately, one's opinion on the subject is often related to one's perspective on the marketplace.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.