Whether you are a long term investor or a day trader, you would like to have a sense of why prices move the way they do. One opinion in this regard was published half a century ago in a book entitled “A Random Walk Down Wall Street.” What is the random walk theory? How does it affect your day trading or long term investments? Do theories of this sort really have any bearing on your trading within the confines of a single trading session?
Introducing the Random Walk Theory and its History
A random walk is a concept from probability theory. The random walk is a series of events or changes that have no relationship to past events and therefore cannot be accurately predicted. The author of “A Random Walk Down Wall Street” contended that totally accurate predictions of price movement are not possible. His premise was that the market prices stocks based on risk. Riskier investments are priced lower because of the risk but have the potential to be more profitable if enough are purchased to essentially eliminate the risk.
Exploring the Basics of Random Walk Theory
If the random walk theory is true, an investor or trader cannot perform any better than the market. The assumption is that the market works with the information that it has and prices assets fairly on that basis. The “bottom line” of the random walk theory is that the best approach is to buy and hold assets that represent the broader market like an ETF that tracks the S&P 500. A random walk prediction that is surprising to some is that a large collection of “high risk” investments will pay better over long period of time that low risk investments.
Examining Random Walk with Drift
If the stock market were truly random, prices would go up and down in equal measure. However, the stock market tends to go up with the US economy. It also heads down during a market correction or crash. This “drift” is non-random. Short term pricing has a somewhat random component, driven by market sentiment. Long term prices are driven by fundamental factors such as company financials and factors that drive profits, such as interest rates.
Illustrating the Mean Reversion Process in Random Walks
Reversion to the mean is the tendency in a truly random walk for values that have gone up to correct back downward and vice versa. This makes sense in a truly random walk or situation. Day traders see this during a single trading session as the market bids prices up and down even when the overall trend is up or down. In the longer term, proponents of the random walk note that bull markets always end and correct and bear markets always end and recover. Those who doubt the validity of the random walk hypothesis in the stock market note that investments before a stock market crash tend to recover and go on up.
The Benefits and Limitations of Random Walks
There is a simple benefit of understanding the occasional randomness of price changes in commodity futures, currencies, and stocks. Day traders profit by anticipating breakouts and the return to a mean. A problem with the random walk approach is that it may encourage a day trader to leave a potentially profitable upward or downward trend when staying in the trade could have lucrative. A long term benefit of the random walk approach is when an investor invests in enough small and risky investments so that the blockbuster gains of a few overcome the losses of the many.
Analyzing the Application of Random Walk Theory in Finance
There are lots of successful long-term investors. There are lots of successful day traders. One group uses fundamental analysis and the other uses technical analysis. In both cases, they make money by paying attention and predicting where the markets will go. If commodity, currency, and stock markets were truly random, it would not be possible to profit by exercising discipline in entering, managing, and exiting trades. As we routinely demonstrate at DayTradeSafe, it is possible to gain routine profits while day trading commodity futures, stocks, or currencies.