The random walk is a phenomenon used in statistics, which suggests a variable follows no discernible trend and moves at random. It also has an application in trading and finance. In the case of investing, the theory suggests that the changes in stock prices are independent of each other and have the same distribution.
According to this theory, investors cannot use the movement or trend of a stock price in the past to predict its future movement. In essence, the theory suggests that any prediction or estimation based on historical information of stock does not matter as there is no predictable path that the price of a stock can take. Instead, the movement is random.
How does the Random Walk Theory apply to investments?
The random walk theory believes that historical stock prices depended on the information that was available in the past. Therefore, in the present, stock prices are not dependent on historical information because the information available in the present may differ.
Through its efficient market assumption, the theory also suggests the price of a stock will already incorporate any predictions or forecasts related to it. It is based heavily on the premise that investors cannot use techniques that use historical information to predict future outcomes because of the unpredictability or randomness of stock prices.
What does the Random Walk Theory implicate?
The random walk theory by implying that it is not possible to predict the movement of prices, suggests that investors cannot outperform the market in the long run. It, therefore, infers that to outperform the market, investors must take large amounts of additional risk. Furthermore, it does not consider the use of technical or fundamental analysis tools dependable.
What are the advantages and disadvantages of the Random Walk Theory?
There are various advantages and disadvantages that the theory has. Firstly, it provides investors with a cost-effective way of investing in the form of exchange-traded funds. Similarly, many popular predictions and forecasts related to stocks and markets have failed in the past, which further strengthens the suggestion made by the theory.
What are the limitations of the Random Walk Theory?
There are several limitations of the random walk theory. Firstly, it assumes an efficient market in which the prices of stocks reflect all available information. Secondly, it fails to compensate for the fact that the stock market has a large number of participants or investors. Each participant spends a different amount on the market. Therefore, patterns or trends may emerge in the prices of securities in the market.
Through the use of these trends, investors can outperform the market by following the patterns and strategically buying and selling stocks. Similarly, for some stocks, their prices may follow specific trends, even in the long run. Furthermore, some experts believe that several factors affect the price of a stock. Therefore, it may not always be possible to identify it. However, that does not mean a pattern does not exist at all.
Conclusion
Random walk suggests that a variable does not follow a trend or pattern but moves randomly. In finance and investing, the random walk theory suggests that investors cannot use predictive methods to estimate the future price of a stock. Therefore, it believes the use of technical and fundamental analysis tools is futile.
Originally Published Here: What is Random Walk
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