06) Financial Concepts: Random Walk Theory

by · October 6, 2010

This theory became highly popular because of a book – A Random Walk Down Wall Street, written by Burton Malkiel in 1973. This book is now regarded as an investment classic.

The random walk theory states that past movement of the price of the overall market or stock cannot be the basis for predicting future movement. In 1953 Maurice Kendall also stated that fluctuations in stock price are independent of each other and have the same probability distribution that prices have a steady upward trend over a period of time. Simply put, stocks have a random and unpredictable path.

The probability for the future price of stock to go up is the same as it has going down. Those who follow this theory believe that it is impossible to outperform the market without the assumption of additional risk. Malkiel further states in his book that both technical analysis and fundamental analysis are mainly a waste of time and remain largely unproven in outperforming markets.

The author also suggests that a long-term buy-and-hold strategy is preferred instead of individuals attempting to time the markets. He also says that technical, fundamental, or other types of analysis are ineffective. His defense is statistics showing mutual funds have always failed to beat benchmark averages like the S&P 500.

Today, people have fast and easy access to significant news and stock quotes. This means investing is no longer limited to the privileged, although many still follow the preachings of Malkiel over 30 years ago. Malkiel’s theory has never been very popular with Wall Street. Part of the reason perhaps is because it does not make use of the concepts of analysis and stock picking.

It is difficult to say how much truth there is to this concept. There is evidence to support both sides. We recommend you pick a copy of Malkiel’s book and be the judge.