Posted by The Random Walk Theory states that stock market’s price movement will not follow any specific pattern or trends and that past price movements cannot be used to predict future price movements.
Stock prices fluctuate in a random and unpredictable path. The random walk theory is a school of thought that believes that it is impossible to outperform the market without assuming additional risk. Critics of the theory, however, contend that stocks do maintain prices trends over time – in other words, that it is impossible to outperform the market by carefully selecting entry and exit points for equity investments.
This theory was discussed widely when the author of this theory, Burton Malkiel published the book (1973), “A Random Walk Down Wall Street”.
Random Walk Theory is a special case of a general efficient-market model or hypothesis.
Efficient Market Hypothesis
This is an investment theory that states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the Efficient Market Hypothesis, stock always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
The conclusion of this theory is that it is impossible to outperform the overall market through expert stock selection or market timing. In such a scenario, the only way an investor can possibly obtain higher returns is by purchasing riskier investments. Although it is cornerstone of modern financial theory, the Efficient Market Hypothesis is highly controversial and often disputed. Believers argue that it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis. While one school of thought supports Efficient Market Hypothesis, an equal amount of dissension also exists. For example, investors, such as Warren Buffett have consistently beaten the market over long period of time, which by definition is impossible according to EMH.
Detractors of the EMH also point to events, such as the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over 22% in a single day, as evidence that stock prices can seriously deviate from their fair values.
Combining the Random Walk Theory together with the Efficient Market Hypothesis, we can possibly conclude that we can have three forms of the hypothesis:
1- Weak Form of Efficiency: One of the different degrees of efficient market hypothesis (EMH) that claims all past prices of a stock are reflected in today’s stock price. This weak form of efficient market hypothesis is popularly known as Random Walk Theory. Therefore, if the weak form of efficient market hypothesis is assumed to be true, then technical analysis cannot be used to predict and beat a market.
2- The Semi-Strong Form of Efficiency: A class of Efficient Market Hypothesis says that current market prices of stocks not only reflect all informational content of historical prices but also reflect all publicly available knowledge about the companies being studied. Furthermore, the semi-strong form says that efforts by analysts and investors to acquire and analyze public information will not yield consistently superior returns to the analyst. Examples of the type of public information that will not be of value to the analyst include corporate reports, corporate announcements, information relating to corporate dividend policy, forthcoming stock splits, etc. This is because, the theory believes that when the information is made publicly available, it is absorbed and reflected in the stock price i.e. all publicly available information is discontinued into a stock’s current share price. Even if the adjustment is not the correct one, the analyst would not be able to obtain consistently superior returns. This is because, incorrect adjustments may be over-adjustments and others, under-adjustments. Thus, the analyst will not be able to develop an effective trading strategy for consistent returns. Tests of the semi-strong form of the Efficient Market Hypothesis have tended to provide support for the hypothesis. These tests were indirect in nature – for example, price movement was tracked after corporate action announcement, such as dividend or stock split, etc.
Thus, according to this theory, neither fundamental nor technical analysis can be used to achieve superior and consistent returns.
3- Strong Form of Efficiency: The strong form of efficient market hypothesis maintains that not only is publicly available information not of any relevance for an investor or analyst to achieve consistently superior returns, but that all information is completely useless. Specifically, no information that is available; be it, public or “inside”, can be used to earn consistently achieve superior returns.
The strong form of efficient market hypothesis states that two conditions are met:
- Successive price changes or return changes are identically distributed – i.e., these distributions will repeat themselves over time.
- When news information is readily available, stock prices will instantaneously adjust to reflect it.
Thus, all information in a market, whether public or private, is expected to be discounted in the stock price. This degree of market efficiency implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to.
The more general efficient market model acknowledges that the markets may have some imperfections, such as transactions costs, information costs, and delays in getting pertinent information to all market participants. But it states that these potential sources of market inefficiency do not exist to such a degree that it is possible to develop trading systems whose expected profits or returns will be in excess of expected normal, equilibrium returns or profits. In this case, equilibrium profits are defined as the excess earnings generated from a simple buy-and-hold strategy.
Efficient Market Hypothesis in Indian Stock Markets
As per study conducted on bonus issued in Indian stock markets between 1990-95, it was found that the returns on shares of companies that issued bonus (stock dividend) was as high as 60% over a period of four-and-half months before the announcement of bonus. After the bonus issue date, the returns on the stocks were found to be insignificant. This indicates the presence of efficient market hypothesis in the Indian stock markets.
Another study conducted on impact of budget on share prices indicates that the market discounted most of the information in the stock prices, well before the announcement. This is also an indication of efficient market hypothesis being relevant in Indian stock markets.
But the extent of the strength of Efficient Market Hypothesis in Indian Stock Markets is subject to debate, given the fact that many instances of scams as well as insider trading have found to have provided profits to certain individuals.
Studied by Firth (1976, 1979, & 1980) in the United Kingdom have compared the share prices existing after a takeover announcement. Firth found that the share prices were fully and instantaneously adjusted to their correct levels, thus concluding that the UK stock market was semi-strong-form efficient.
Weak form of efficiency does not require that prices remain at or near equilibrium, but only that market participants will not be able to systematically profit from market “inefficiencies as well as the bear market rally in March-April 2009 are prime examples of this form of market efficiency.
Modern Portfolio Theory: Concept of the Optimal Portfolio
The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other things) that investors fanatically try to minimize risk while striving for the highest return possible. The theory states that investors will act rationally and always making decisions aimed at maximizing their return for their acceptable level of risk.
The optimal portfolio was used in 1952 by Markowitz, and it shows us that it is possible for different portfolios to have varying levels of risk and return. Each investor must decide how much risk they can handle and then allocate (or diversify) their portfolio according to this decision.
The optimal-risk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up the curve, you take on proportionately more risk for a lower incremental return. On the other end, low risk / low return portfolios are pointless because you can achieve a similar return by investing in risk-free assets, like government securities.
An investor can choose the extent of risk – return payoff that he/she wants. The extent of volatility the investor is willing to bear can determine the extent of returns earned. This will give the investor, the maximum return for the amount of risk he/she wishes to accept. Optimizing the portfolio returns is a complicated process, resulting in several permutations for building the portfolio. There are dedicated computer programs that determine optimal portfolios by estimating hundreds (and sometimes thousands) of different expected returns for each given amount of risk.
