Random Walk Theory

- *Random means: Made, done, happening, or chosen without method or conscious

decision.
- A random walk is a mathematical formalization of a path that consists of a
succession of random steps The term random walk was first introduced by Karl
Pearson in 1905. Random walks have been used in many fields: ecology, economics,
psychology, computer science, physics, chemistry, and biology.
- In, 1953, Maurice Kendall, a distinguished statistician, presented a somewhat unusual
paper before the Royal Statistical Society in London. Kendall examined the behaviour
of stocks and commodity prices in search for regular cycles. Surprisingly he found the
series to be a wandering one rather than a regular cycle.
Definition: A theory about the market stating that it is impossible to predict the
direction of price movement, and that any price today has a 50% chance of rising or
falling.
- The random walk theory raised many eyebrows in 1953 when author Burton Malkiel
coined the term in his book "A Random Walk Down Wall Street." 1 The book
popularized the efficient market hypothesis (EMH), an earlier theory posed by
University of Chicago professor William Sharp. The efficient market hypothesis
states that stock prices fully reflect all available information and expectations, so
current prices are the best approximation of a company’s intrinsic value. This would
preclude anyone from exploiting mispriced stocks consistently because price
movements are mostly random and driven by unforeseen events.
- A random walk means that successive stock prices are independent and identically
distributed.
- Also called Weak form of market efficiency.
- Also called drunkard’s walk is based on the premise that one takes a number of
successive steps.
- The random walk theory states that market and securities prices are random and not
influenced by past events.
 Example. Say there is a garments company whose stock is trading at $100. Suddenly
there is news of the fire in the factory, and Stock Price fell by 10%. The next day
when the market started, the stock price fell by another 10%. So, what Random Walk
Theory says is that they fall on the fire day was due to the news of the fire, but they
fall on the next day was not on the news of fire again, it was due to any updated news
on fire say an exact number of fabrics burned that caused the fall on the next day. So,
Stock Prices are not dependent on each other. Each day stock reacts with various
news and is independent of each other
- Put differently, prices appeared to follow a random walk, implying that successive
prices changes are independent of one another. On the other hand, the theory of
random walks says that successive price changes are independent, that is, the past
cannot be used to predict the future.
- Random Walk Theory says that in an Efficient market, the stock price is random
because you can’t predict, as all information is already available to everyone and how
they will react depends on their financial needs and choices.
- Random walk theory believes it's impossible to outperform the market without
assuming additional risk. It considers technical analysis undependable because
chartists only buy or sell a security after an established trend has developed. Likewise,
the theory finds fundamental analysis undependable due to the often-poor quality of
information collected and its ability to be misinterpreted.
- theory suggests that changes in stock prices have the same distribution and are
independent of each other.
- theory infers that the past movement or trend of a stock price or market cannot be
used to predict its future movement.
- theory believes it's impossible to outperform the market without assuming additional
risk.
- theory considers technical analysis undependable because it results in chartists only
buying or selling a security after a move has occurred.
- theory considers fundamental analysis undependable due to the often-poor quality of
information collected and its ability to be misinterpreted.
- theory claims that investment advisors add little or no value to an investor’s portfolio.
- Critics of the theory contend that stocks do maintain price trends over time – in other
words, that it is possible to outperform the market by carefully selecting entry and exit
points for equity investments.
- Sharp and Malkiel concluded that, due to the short-term randomness of returns,
investors would be better off investing in a passively managed, well-diversified fund.
A controversial aspect of Malkiel’s book theorized that "a blindfolded monkey
throwing darts at a newspaper's financial pages could select a portfolio that would do
just as well as one carefully selected by experts."2
- Fundamental or intrinsic value analysis is useless in a random-walk-efficient market.
- The randomness of stock prices was the result of an efficient market. Broadly, the key
links in the argument are as follows:
1. Information is freely available to all the market participants.
2. Keen competition among market participants more or less ensure that market prices
will reflect intrinsic values.
3. Prices changes only in response to new information.
4. Prices behave like a random walk (change price will not follow any pattern).
Assumptions:

1. Market is supreme and no individual investor or group can influence it.

2. Stock prices discount all information quickly.

3. Markets are efficient and that the flow of information is free and unbiassed.

4. All investors have free access to the same information and nobody has superior knowledge
or expertise.

5. Market quickly adjusts itself to any deviation from equilibrium level due to the operation
of free forces of demand and supply.

6. Market prices change only on information relating to the fundamentals, when the
equilibrium level itself may shift.

7. These prices move in an independent fashion, within undue pressures or manipulation.

8. Nobody has better knowledge or insider information.

9. Investors behave in a rational manner and earned and supply forces are the result of
rational investment decisions.

10. Institutional investors or any major fund managers have to follow the market and market
cannot be influenced by them.

11. A large number of buyers & sellers and perfect market conditions of competition will
prevail; Random Walk and

12.The theory assumes that the security prices in the stock market follow a random walk.

13. It also assumes that the movement in the price of one security is independent of another.

*If the Random Walk Theory is true, then all forms of analysis are useless.

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