Random Walk Hypothesis

“A Random Walk Down Wall Street” was one of the most delightful books that I have ever read. I disagree with most of what the book says, but it still makes a very interesting read.

This book popularized the “Random Walk Hypothesis”.  The Random Walk Hypothesis states that stock prices move in a random manner and no one can predict stock prices.

Burton Malkiel, the author of the book says that it is a waste of time to conduct technical or fundamental research. It is impossible to come to any reasonable conclusion of the direction that a stock is going to take by doing any sort of analysis.

After reading the book, I always felt that Burton Malkiel was saying that the analysis of stock prices will not help you decide the direction in which the stock price is headed in the future. His experiments mainly included studying past prices and then trying to extrapolate them to future stock prices. The conclusion was that it is not possible to study past prices and decide future trends.

I agree with this part of the theory. You can’t study past prices and predict future prices. Doing this completely ignores the future of the company that the stock belongs to. Afterall, a stock is nothing but ownership in a company. If you ignore the future prospects of the company itself, there is no way to determine whether it will do well or not. If you do not know whether the company will do well or not, how can you ever tell if the stock price will do well or not?

The theory also promotes buying and holding for the long term. This is also something that I agree with. The secret to great riches in the stock market is holding a stock for a fairly long term. It is very rare to find people who have made their money by buying and selling stocks every day or every few months. Real money is made when you take ownership in a company which is growing and then let the stock price grow ten, twenty times over a period of a few years.

The part that I disagree with is that stock prices can’t be predicted. You may not be able to predict how the market is going to behave tomorrow or even a year from now. But if you buy the stock of a fundamentally strong company at a decent price, you can be rest assured that the price will go up in years to come.

This is a big difference in opinion. Proponents of the Random Walk Hypothesis state that you should be satisfied with buying Index Funds and earning the same returns as the Index. People who oppose it, think more money can be made by selecting the right stocks and staying with them for a few years. It is natural to find more people oppose the Random Walk Hypothesis, because accepting it means that they can’t beat the markets. And of course, investors like Peter Lynch, George Soros, Warren Buffet and several others have shown that it is in fact possible to beat the market consistently and instill hope in many others.

On the other hand, most mutual funds have returned lesser profits to investors, when compared with index funds. This shows that, it really is better to buy index funds and hold them for a longer period for most investors.

Both sides have strong evidence, which side are you on?