Random walk theory

This theory stands as the main adversary and critic of the efficient market theory. The concept of random walks dates back to 1863 with the work of French broker Jules Regnault. It was later followed in 1900 by mathematician Louis Bachelier's work titled "The Theory of Speculation," which presented several interesting insights on this topic. Similar ideas were explored by management professor Paul Cootner in his 1964 book "The Random Character of Stock Market Prices."

The promotion and popularization of the term random walk were significantly influenced in 1973 by Princeton University economics and finance professor Burton Malkiel through his work A Random Walk Down Wall Street. By using the concept of a random walk, Malkiel claims that price movements in the market are unpredictable. Due to this randomness, investors cannot consistently outperform overall market trends. Applying fundamental or technical analysis is a waste of time that simply leads to lower performance. Instead, investors should focus on buying and holding index funds. Malkiel presents two popular investment theories that correspond to fundamental and technical analysis:

1. From a fundamental perspective, the "firm-foundation theory" states that securities have intrinsic value, which can be determined by discounting future cash flows. Investors can also use valuation techniques to discover the true value of a security or the market itself. Investment decisions to buy or sell are made based on these assessments.
2. From a technical perspective, the "castle-in-the-air theory" suggests that successful investing depends on behavioral finance. Investors must gauge the market sentiment— whether it is bullish or bearish. Valuations are not important, as a security is only worth what someone else is willing to pay for it.

The random walk theory challenges the efficient market hypothesis with its claim that it is not possible to consistently outperform the market. This theory asserts that stock or other security prices are efficient because they reflect all known information (such as earnings, expectations and dividends). Prices quickly adjust to new information, making it virtually impossible to react instantly to these updates. Furthermore, prices only move when new information arrives, and this information is random or unpredictable.

Opponents of the random walk theory point to market inefficiencies that create opportunities to predict or anticipate changes in securities under certain circumstances with better-than-random accuracy. These inefficiencies include incomplete or conflicting information about companies, as well as the market's tendency to overreact or underreact to various types of news and stimuli. While many aspects of price movements remain ambiguous, the general concept of the random walk continues to dominate among numerous market analysts and economists and will continue to drive new research and discussions in the near future.

Sources:

1. https://www.referenceforbusiness.com/encyclopedia/Pro-Res/Random-Walk-Theory.html

2. https://www.investopedia.com/terms/r/randomwalktheory.asp
   

3. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/what-is-the-random-walk-theory/ 
   

4. https://stockcharts.com/help/doku.php?id=chart_school:overview:random_walk_theory 

5. https://www.investopedia.com/university/concepts/concepts5.asp 

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