What Is the Random Walk Hypothesis?

By Markets Fool.com


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Many theorists examine the behavior of stock prices, and the random walk hypothesis attempts to explain why stocks move the way they do. The random walk hypothesis states that stock market prices change in a random manner, and therefore, you can't predict what price movements will occur in advance. The theory argues that each change is independent of previous changes, and so the trends that many investors see in stock charts aren't meaningful. Made popular by Professor Burton Malkiel of Princeton in his 1973 book A Random Walk Down Wall Street, the random walk hypothesis has implications for both short-term traders and long-term investors.

What a random walk is

The name of the random walk hypothesis refers to the broader concept of the random walk, which is a mathematical construct that describes a succession of random events. In finance, the hypothesis assumes that financial markets stock price changes are the random events.

The random walk hypothesis is closely related to the efficient market hypothesis, which also points to the futility of trying to make predictions about stock price movements. The efficient market hypothesis says that stock prices incorporate all available information that's relevant to the underlying company's financial prospects, and so any movement in the stock price that doesn't result from new information is essentially random. Moreover, if you believe that new information affecting a stock is as likely to be positive as it is negative, then the flow of that information is also a random event. That further supports the random walk hypothesis and its explanation of stock price movements.

Has the random walk hypothesis been proven?

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The random walk hypothesis is antithetical to the views of any investor who believes that the stock market is predictable. Opponents of the hypothesis argue that the assumptions made by the theory are incorrect, and some believe they have definitively disproven the theory.

Some of those who argue against the random walk hypothesis point to certain events that produce non-random movements in future stock prices. For instance, the 1999 book A Non-Random Walk Down Wall Street,by Professors Andrew Lo and A. Craig MacKinlay, concludes that some predictable aspects do exist in share-price movements. One of the arguments the book makes is that technology will allow computers using high-frequency trading algorithms to exploit extremely short-term anomalies in the stock markets, something that many market participants have increasingly experienced and criticized in their own investing.

More positively, long-term investors argue that even if short-term stock price movements are random, success in the long run depends on the performance of the underlying business. Some proponents extend the hypothesis to the conclusion that you can randomly pick stocks with an equal chance of success. But these opponents argue that the traits of successful companies are not random and that the efficient market hypothesis doesn't accurately take into account the information that allows investors to judge which companies are most likely to succeed.

The random walk hypothesis has merit in dissuading investors from trying to make guesses about short-term stock movements. However, many long-term investors still manage to invest well by putting time on their side.

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