How to Profit From “A Random Walk Down Wall Street”

Last week, I wrote about several market theories: the greater fool theory, the prospect (loss-aversion) theory, and the efficient market hypothesis. This week, I’ll be discussing just one theory – the random walk theory. Because it’s so consequential, and because it proposed such a large separation from ever so popular technical analysis, this theory has been hotly debated since it initially became prevalent in the 1970s.

First popularized in Burton Malkiel’s 1973 book, “A Random Walk Down Wall Street,” the random walk theory essentially states that stock price changes occur randomly and independently of one another. This conclusion is in part a result of the efficient market hypothesis, which as I explain here, states that stock prices reflect all available information about a stock, making it impossible to buy an undervalued company. Because information about stocks emerges randomly, the prices of stocks (if one accepts the efficient market hypothesis) also move randomly.

To test the random walk theory, Malkiel ran an experiment with his students at Princeton University. In the experiment, the class began with a fictitious stock valued at $50 and then flipped a coin every day to determine whether the price of the stock would increase (heads) or decrease (tails) by half a point. After several months of this, Malkiel brought the price history to a technical analyst (someone who analyzes and predicts the price movements of a stock) and asked for his analysis. The analyst reviewed the data and recommended that Malkiel immediately buy the stock. According to Malkiel, this was evidence that the short-term price movements of a stock could be “just as random as flipping a coin.”

Several major consequences of this randomness are that one cannot predict future price movements from past ones and that any perceivable “cycles” or “trends” in a stock’s price are merely the result of random chance. Additionally, in order to beat the market, one must assume greater risk.

So say you believe that the random walk theory is correct, and that there is really no way to determine short term stock price changes. What do you do?

The safest way to avoid the pitfalls of this “random walk” of stock prices is to be a passive investor. Passive investing involves putting together a diverse and well-researched portfolio that is meant to perform in tandem with the market and then letting this portfolio sit without touching it. By doing this, passive investors avoid the losses associated with attempting to time the market, and as a result of trading so infrequently, they are not as susceptible market fads, emotions, or scares.

Additionally, because the random walk theory refers to price changes in the short term, it is still possible to predict the long-term growth of a company (and thus an increase in its stock price). For instance, on January 15th, 2010, Apple (AAPL) stock was worth $29.42 a share. The random walk theory states that it is impossible to predict day to day changes in price, but if someone were to identify that Apple was a strong company, or that mobile devices were becoming increasingly popular and Apple was well positioned to take advantage of this, then they could invest in the company with the hope of long-term returns. Fast forward to today, and Apple is trading at $152.96 (May 19th, market close). Our hypothetical investor profited because they invested in the long-term growth of a company, not the short-term change in the price of a stock.

The Dynalect Team has always believed in this buy and hold strategy, which is why we publish market reports that aim to predict an entire industry and the companies related to it that we feel have high growth potentials. Look to investors like Warren Buffett and you’ll see that in order to find success in the stock market it is best to practice strategies that avoid attempts to predict and time the market, instead focussing on the value and growth potential of companies themselves

See you next week,

Zach

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