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. How they will react depends on their financial needs and choices.

An efficient market is a market with transparency and general information; future earnings are taught 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 was 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. 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 to various news and is independent of each other.

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How Does Random Walk Theory Work?

  • Random Walk Theory is practical and has proven correct in most cases. The theory says that if Stock Prices are random, 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. Suppose all the other theories that provide ways to predict future stock prices were true. How can 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 a return is with the market itself. That is to invest in ETFs or mimic 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 fund managers charge fees for funds they manage.

How Does Random Walk Theory Apply to Stocks?

  • Stocks movement, as described by Random Walk Theory, is unpredictable. The easiest way to earn money in this world is to invest in stocks and wait for them to grow. So this theory says that if the movement of stock price had been so easy to predict, then everyone would have made a fortune by now. Not all who invest in stocks end up winning. Then how are people losing money?Random Walk criticizes Technical Analysis. This theory heavily criticizes fundamental analysis and technical analysis. Technical analysis says that history repeats. So stock prices follow the trend that they have shown in the past. Random Walk believes that the stock price was as per the information available in the past. Each stock price is independent of the other.It means today’s stock price is not dependent on what the stock price was yesterday. Yesterday’s price was based on available information, and today, the stock price is based on available information. Everyone has access to all the information. Insider informationInsider InformationInsider Information is a piece of fact, information or an understanding (M&A, New Contracts, R&D breakthrough, new product launch etc.) which could impact the prices of a listed entity or publicly-traded organizations once disclosed in the public domain. Trading based on such information is considered to be illegal.read more is not included in this theory.Random Walk Theory is based on the weak-form efficient market hypothesisEfficient Market HypothesisThe efficient market hypothesis (EMH) states that the stock prices indicate all relevant information and are universally shared, making it impossible for investors to earn above-average returns consistently. Economist Eugene Fama gave the idea of the efficient market hypothesis in the 1960s.read more, which states that all the available information is already taught in the stock price. Suppose there is any prediction of future earnings, then that earning’s present value is also taught in the stock price. The trading is between informed buyers and informed sellers, and it depends on what they would like to do. So ultimately, it is random.

Implications of Random Walk Theory

  • Stock Prices are random, so instead of spending money on Fund Managers, one should buy ETFsETFsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more or spend on stocks in the exact quantity of an index.Technical analysisTechnical AnalysisTechnical analysis is the process of predicting the price movement of tradable instruments using historical trading charts and market data.read more or fundamental analysis doesn’t work in predicting the stock price as it is impossible to predict it.Stock prices are independent; today’s stock price has no relation to yesterday’s stock price.Markets are efficient, information is readily available, and informed decisions are always taken.

Advantages of Random Walk Theory

  • It provides a cost-effective way of investing. That is an investment in ETFs.In many situations, the market has not acted as predicted, proving that stock prices are indeed random.

Disadvantages of the Random Walk Theory

  • Markets are not entirely efficient. Information asymmetryInformation AsymmetryAsymmetric information is the knowledge mismatch that happens when one party secures more information about a product or service than the other party to the transaction. The information failure is often seen when the seller is more informed about a product’s condition than the buyer.read more is there, and many insiders react much earlier than other investors due to the information edge.In many cases, stock prices have shown a trend year on year.One lousy news affects a stock price for several days, even months.

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 managers, 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 random walk theory works and an example and implication. We also discuss the advantages and disadvantages. You can learn more about Financing from the following articles –

  • Types of Expectations TheoryFrontier MarketInefficient MarketEfficient Frontier PortfolioFactor Models