Financial Concepts: Random Walk Theory

In 1973, investment guru Burton Malkiel wrote “A Random Walk Down Wall Street,” a book which is now regarded as an investment classic. “Random walk theory” took its name from this book, and it is an attempt to explain the way that the stock market moves. Essentially, the theory states that the past movement or direction of the price of either the overall market or of an individual stock is not a suitable predictor of future movement. The theory was originally described by Maurice Kendall in 1953, and it states that stock price fluctuations are independent of one another, that they have the same probability distribution, and that over a period of time, prices maintain an upward trend.

Essentially, this theory holds that stock prices take a random path, and one that is unpredictable. Regardless of what has happened in the past, the chance of a stock’s future price going up is the same as the chance of it going down. Practitioners of the theory believes that it is impossible to outperform the broader market unless one takes on additional risk. Malkiel advised in his book that both technical analysis and fundamental analysis are, effectively, a waste of time, and they are still unproven in being able to outperform markets over the long term.

As a result of these ideas, Malkiel and other believers in the random walk theory believe that a long-term buy-and-hold strategy is the most effective, and that any attempts to time the market are futile. In the book, Malkiel backs up this assertion with statistics that show that most mutual funds fail to beat benchmark averages, including the S&P 500.

Although Malkiel’s work is decades old at this point, many investors still hold that some or all of his ideas are true. Other investors, on the flipside, believe that the investing world is quite different now than it was more than four decades ago. Today, relevant news and up-to-date stock quotes are available to virtually every investor, and investing is no longer limited to those who are privileged. Wall Street money managers have never believed that random walk is particularly valuable, likely because they hold that analysis and stock picking are worthwhile means of making investment decisions.

It’s likely that investors will never know for sure exactly how much truth there is to Malkiel’s theory, as there is evidence that supports both sides of the argument. Investors interested in forming their own opinions would be advised to pick up a copy of the book and read it for themselves.