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What is a Random Walk?

When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Since real news develops randomly, that is it can not be predicted by studying either past technical or fundamental information, it means that Investment newsletters, earnings predictions, and complicated chart patterns are totally useless. Taken to its logical extreme, a blindfolded monkey throwing darts at a newspaper’s financial pages should be able to select a portfolio expected to do just as well as one carefully chosen by the experts. – Burton Malkiel, A Random Walk Down Wall Street

What is a Random Walk?

The Random Walk Theory

The random walk theory presents an important challenge to all forms of active management. It explains why it is not possible to build a consistent track record of predictions for guiding asset allocation decisions to navigate ups and downs in the economy and turning points in the market.;

The random walk theory implies that short run changes in stock prices cannot be predicted. If prices reflect all available information at any given time, then subsequent changes in price can only be due to new information. News develops randomly therefore the change in price must arise from new, previously unforeseen, and unforeseeable information. Hence, prices themselves must change unpredictably and randomly. If past prices contain little useful information for the prediction of future prices, then the implication is that there is no point in following any technical trading rule for timing the purchases and sales of securities (Gene Fama, Univ. of Chicago, Random Walks). 

No one claims the market is a perfect random walk or that technical and fundamental strategies never make money. They very often do make profits. The point is that the past history of stock prices cannot be used to predict the future in a meaningful way and a simple buy and hold strategy for a long period of time typically makes more money.

Mutual funds, financial advisors and wealth managers, in their advertising to investors, often claim that their strategy or investment model is better able to detect good buys and guard your wealth against the economy’s ups and downs. They claim to provide a higher return than would be earned by a portfolio of randomly selected securities or a passively managed portfolio of index mutual funds and ETFs.

Prevailing investment wisdom delivered by most of Wall Street and the news media, whose ratings depend on the excitement they generate, is focused on advancing their own interests. As with most things in life, ultimately you need to watch out for your own interests. Investment strategies based on forecasting tools and early warning signals tend to break down when they are needed most, when the economy and financial markets take sudden, pronounced shifts in direction.

Don't allow yourself to be misled by the false promise of forecasting skill. Numerous studies (see Active vs Passive portfolio management) show that on average passively managed index mutual funds and ETFs outperform most active investment efforts. This leads random walk theorists to conclude that financial institutions, active mutual fund managers and most wealth management advisors, despite their claims, probably don't outperform the markets.

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