Financial Concepts: Random Walk Theory
|Investopedia: Are you looking for more information on currency trading? Try our Forex Walkthrough, it goes from beginner to advanced.|
Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic. Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. Originally examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are independent of each other and have the same probability distribution, but that over a period of time, prices maintain an upward trend.
In short, random walk says that stocks take a random and unpredictable path. The chance of a stock's future price going up is the same as it going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk. In his book, Malkiel preaches that both technical analysis and fundamental analysis are largely a waste of time and are still unproven in outperforming the markets.
Malkiel constantly states that a long-term buy-and-hold strategy is the best and that individuals should not attempt to time the markets. Attempts based on technical, fundamental, or any other analysis are futile. He backs this up with statistics showing that most mutual funds fail to beat benchmark averages like the S&P 500.
While many still follow the preaching of Malkiel, others believe that the investing landscape is very different than it was when Malkiel wrote his book nearly 30 years ago. Today, everyone has easy and fast access to relevant news and stock quotes. Investing is no longer a game for the privileged. Random walk has never been a popular concept with those on Wall Street, probably because it condemns the concepts on which it is based such as analysis and stock picking.
It's hard to say how much truth there is to this theory; there is evidence that supports both sides of the debate. Our suggestion is to pick up a copy of Malkiel's book and draw your own conclusions.
Next: Financial Concepts: Efficient Market Hypothesis »
Table of Contents
- Financial Concepts: Introduction
- Financial Concepts: The Risk/Return Tradeoff
- Financial Concepts: Diversification
- Financial Concepts: Dollar Cost Averaging
- Financial Concepts: Asset Allocation
- Financial Concepts: Random Walk Theory
- Financial Concepts: Efficient Market Hypothesis
- Financial Concepts: The Optimal Portfolio
- Financial Concepts: Capital Asset Pricing Model (CAPM)
- Financial Concepts: Conclusion
comments powered by Disqus