Random Walk Theory

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 they will 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.

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.

Random Walk Theory

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Random Walk Theory (wallstreetmojo.com)

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 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 the 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 the future were 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 of fund managers charge fees for funds they manage.

How Does Random Walk Theory Apply to Stocks?

Implications of Random Walk Theory

Advantages of Random Walk Theory

  • It provides 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

Conclusion

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 passivelyInvest PassivelyPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.read more in ETFs.

This article has been a guide to what is random walk theory and its definition. Here we discuss how does random walk theory works along with an example and implication. We also discuss the advantages and disadvantages. You can learn more about Financing from the following articles –