Random walk hypothesis

Random walk hypothesis

The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It has been described as 'jibing' with the efficient market hypothesis. Economists have historically accepted the random walk hypothesis. They have run several tests and continue to believe that stock prices are completely random because of the efficiency of the market.

The term was popularized by the 1973 book, "A Random Walk Down Wall Street", by Burton Malkiel, currently a Professor of Economics and Finance at Princeton University,cite book|last=Malkiel|first=Burton G.|title=A Random Walk Down Wall Street|edition=6th|publisher=W.W. Norton & Company, Inc.|year=1973|isbn=0393062457] and was used earlier in Eugene Fama's 1965 article "Random Walks In Stock Market Prices", [cite journal|last=Fama |first=Eugene F. |author-link= Eugene Fama|year=1965 |month=September/October |title=Random Walks In Stock Market Prices |journal=Financial Analysts Journal |volume=21 |issue=5 |pages=55–59 |url=http://www.cfapubs.org/toc/faj/1965/21/5 |accessdate=2008-03-21 |doi=10.2469/faj.v21.n5.55] which was a less technical version of his Ph.D. thesis. The theory that stock prices move randomly was earlier proposed by Maurice Kendall in his 1953 paper, "The Analytics of Economic Time Series, Part 1: Prices". [cite journal
title=The Analysis of Economic Time-Series-Part I: Prices
first=M. G.
author-link=Maurice Kendall
journal=Journal of the Royal Statistical Society
series=A (General)

Testing the hypothesis

Burton G. Malkiel, an economist professor at Princeton University and writer of "A Random Walk Down Wall Street", performed a test where his students were given a hypothetical stock that was initially worth fifty dollars. The closing stock price for each day was determined by a coin flip. If the result was heads, the price would close a half point higher, but if the result was tails, it would close a half point lower. Thus, each time, the price had a fifty-fifty chance of closing higher or lower than the previous day. Cycles or trends were determined from the tests. Malkiel then took the results in a chart and graph form to a chartist, a person who “seeks to predict future movements by seeking to interpret past patterns on the assumption that ‘history tends to repeat itself’”.cite book|last=Keane|first=Simon M.|title=Stock Market Efficiency|publisher=Philip Allan Limited|year=1983|isbn=0860036197] The chartist told Malkiel that they needed to immediately buy the stock. When Malkiel told him it was based purely on flipping a coin, the chartist was very unhappy. Malkiel argued that this indicates that the market and stocks could be just as random as flipping a coin.

The random walk hypothesis was also applied to NBA basketball. Psychologists made a detailed study of every shot the Philadelphia 76ers made over one and a half seasons of basketball. The psychologists found no positive correlation between the previous shots and the outcomes of the shots afterwards. Economists and believers in the random walk hypothesis apply this to the stock market. The actual lack of correlation of past and present can be easily seen. If a stock goes up one day, no stock market participant can accurately predict that it will rise again the next. Just as a basketball player with the “hot hand” can miss his or her next shot, the stock that seems to be on the rise can fall at any time, making it completely random.

A non-random walk hypothesis

There are other economists, professors, and investors who believe that the market is predictable to some degree. These people believe that prices may move in trends and that the study of past prices can be used to forecast future price direction. There have been some economic studies that support this view, and a book has been written by two professors of economics that tries to prove the random walk hypothesis wrong.

Martin Weber, a leading researcher in behavioral finance, has performed many tests and studies on finding trends in the stock market. In one of his key studies, he observed the stock market for ten years. Throughout that period, he looked at the market prices for noticeable trends and found that stocks with high price increases in the first five years tended to become under-performers in the following five years. Weber and other believers in the non-random walk hypothesis cite this as a key contributor and contradictor to the random walk hypothesis.cite journal|last=Fromlet|first=Hubert|title=Behavioral Finance-Theory and Practical Application|journal=Business Economics|month=July|year=2001|pages=63]

Another test that Weber ran that contradicts the random walk hypothesis, was finding stocks that have had an upward revision for earnings outperform other stocks in the forthcoming six months. With this knowledge, investors can have an edge in predicting what stocks to pull out of the market and which stocks — the stocks with the upward revision — to leave in. Martin Weber’s studies detract from the random walk hypothesis, because according to Weber, there are trends and other tips to predicting the stock market.

Professors Andrew W. Lo and Archie Craig MacKinlay, professors of Finance at the MIT Sloan School of Management and the University of Pennsylvania, respectively, have also tried to prove the random walk theory wrong. They wrote the book "A Non-Random Walk Down Wall Street"cite book|last=Lo|first=Andrew|title=A Non-Random Walk Down Wall Street|publisher=Princeton University Press|year=1999|isbn=0691057745] , which goes through a number of tests and studies that try to prove there are trends in the stock market and that they are somewhat predictable.

They prove it with what is called the simple volatility-based specification test, which is an equation that states:

:X_t = mu + X_{t-1} + epsilon_t,


:X_t is the price of the stock at time "t"

:mu is an arbitrary drift parameter

:epsilon_t is a random disturbance term. With this equation, they have been able to put in stock prices over the last number of years, and figure out the trends that have unfolded.cite book|last=Lo|first=Andrew W.|coauthors=Mackinlay, Archie Craig |title=A Non-Random Walk Down Wall Street|year=2002|publisher=Princeton University Press|pages=4–47|edition=5th|isbn=0691092567] They have found small incremental changes in the stocks throughout the years. Through these changes, Lo and MacKinlay believe that the stock market is predictable, thus contradicting the random walk hypothesis. Lo and MacKinlay have authored a paper, the Adaptive Market Hypothesis, which puts forth another way of looking at predictability of price changes.


Wikimedia Foundation. 2010.

Look at other dictionaries:

  • Random walk — A random walk, sometimes denoted RW, is a mathematical formalization of a trajectory that consists of taking successive random steps. The results of random walk analysis have been applied to computer science, physics, ecology, economics and a… …   Wikipedia

  • Random walk — Theory that stock price changes from day to day are at random; the changes are independent of each other and have the same probability distribution. Many believers of the random walk theory believe that it is impossible to outperform the market… …   Financial and business terms

  • random walk — Theory that stock price changes from day to day are accidental or haphazard; changes are independent of each other and have the same probability distribution. Many believers in the random walk theory believe that it is impossible to outperform… …   Financial and business terms

  • A Random Walk Down Wall Street — Infobox Book name = A Random Walk Down Wall Street author = Burton Malkiel genre = Finance language = English publisher = W. W. Norton Company, Inc. release date = 1973 pages = 456 isbn = ISBN 0 393 06245 7 A Random Walk Down Wall Street ,… …   Wikipedia

  • Efficient-market hypothesis — Financial markets Public market Exchange Securities Bond market Fixed income Corporate bond Government bond Municipal bond …   Wikipedia

  • Noisy market hypothesis — Financial markets Public market Exchange Securities Bond market Fixed income Corporate bond Government bond Municipal bond …   Wikipedia

  • Riemann hypothesis — The real part (red) and imaginary part (blue) of the Riemann zeta function along the critical line Re(s) = 1/2. The first non trivial zeros can be seen at Im(s) = ±14.135, ±21.022 and ±25.011 …   Wikipedia

  • Efficient Market Hypothesis — Die fundamental geprägte Effizienzmarkthypothese (engl. Efficient Market Hypothesis (EMH)) wurde 1970 von Eugene Fama [1] als mathematisch statistische Theorie der Volkswirtschaftslehre zusammengefasst. Sie besagt, dass die Finanzmärkte in dem… …   Deutsch Wikipedia

  • Coherent Market Hypothesis — A hypothesis that the probability density function of the market may be determined by a combination of group sentiment and fundamental bias. Depending on combinations of these two factors, the market can be in one of four states: random walk,… …   Financial and business terms

  • Technical analysis — Financial markets Public market Exchange Securities Bond market Fixed income Corporate bond Government bond Municipal bond …   Wikipedia

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”

We are using cookies for the best presentation of our site. Continuing to use this site, you agree with this.