What is the Random Walk Theory?
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 will they react depends on their financial needs and choices.
An efficient market is a market where there are transparencies and all the already prevailing information, future earnings are inculcated in the stock price. If one buyer is buying a stock, then he is buying it based on any information, that information is also available to the seller who is selling the stock, this is the efficient market, where everyone has got the information and still they do what is good for them according to their personal choice.
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 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 different news and is totally independent of each other.
How Does Random Walk Theory Work?
- Random Walk Theory is practical and has proved to be correct in most cases. The theory says that if Stock Prices are actually random, then why we need to waste money and hire fund managers to manage our money. It may happen that a fund manager has managed to provide an alpha return, but it may be due to luck and luck may not sustain and it may not provide an alpha return in next year.
- Alpha return is the extra return that a fund manager promises to pay over and above a benchmark return. If all the other theories which provide ways to predict stock prices of future were actually true, then how is it possible that so many fund managers who apply both technical and fundamental analysis end up earning the negative or same return as the benchmark. So, if after applying all theories the stock prices can’t be predicted, then obviously it is random.
- In a world where markets are efficient, the only way to earn return is with the market itself. That is to invest in ETFs or to exactly mimicking an Index by buying the same stocks in the same quantities. In this way, the cost of fund managers can be avoided and you will end up earning the same return or maybe more because fund managers charge fees for funds they manage.
How Does Random Walk Theory Apply to Stocks?
- Stocks movement as being described by Random Walk Theory is unpredictable. The easiest way to earn money in this world is to invest in stocks and wait for it to grow. So this theory says that if the movement of stock price would have been really so easy to predict then everyone would have had made fortune by now. Not all who invest in stocks end up winning. Then how are people losing money?
- This theory heavily criticizes fundamental analysis and technical analysis. Technical analysis says that history repeats. So stock prices follow the trend that they have shown in the past. Random Walk criticizes Technical Analysis. Random Walk believes that in the past the stock price was as per the information available in the past. Each stock price is independent of each other.
- This means today’s stock price is not at all dependent on what the stock price was yesterday. Yesterday’s price was based on information available yesterday and today the stock price is based on information that is available today. Everyone has access to all the information. Insider information is not included in this theory.
- Random Walk Theory is based on the weak-form efficient market hypothesis, which states that all the available information is already inculcated in the stock price. If there is any prediction of future earning, then that earnings present value is also inculcated in the stock price. The trading that is happening is between informed buyers and informed seller and it depends on them as to what they would like to do. So ultimately it is random.
Implications of Random Walk Theory
- Stock Prices are random, so instead of spending money on Fund Managers, one should buy ETFs or spend on stocks in the exact quantity of an index.
- Technical analysis or fundamental analysis doesn’t work in the prediction of the stock price as it is impossible to predict it.
- Stock prices are independent, today’s stock price has no relation to yesterday’s stock price.
- Markets are efficient and information is readily available with everyone and informed decisions are always taken.
Advantages of Random Walk Theory
- It provide a cost-effective way of investing. that is an investment in ETFs.
- In many situations market has not acted as predicted, which proves that stock prices are indeed random.
Disadvantages of the Random Walk Theory
- Markets are not completely efficient. Information asymmetry is there and many insiders react much early than other investors due to information edge.
- In many cases, stock prices have shown trend year on year.
- One bad news affects a stock price for several days even months.
Random Walk Theory is being believed by many passive investors as on average the performance of fund managers has failed to outperform the index. So now the belief has grown stronger that no fund manager can beat benchmark year on year, so instead of paying fees to mangers, it’s better to invest passively in ETFs.
This has been a guide to what is random walk theory and its definition. Here we discuss how does random walk theory work along with an example and implication. We also discuss the advantages and disadvantages. You can learn more about Financing from the following articles –