Random Walk Theory

The Random Walk Theory is the idea that stock price changes are independent of each other and have the same probability distribution, making them fundamentally unpredictable. Imagine a drunkard stumbling home from a pub; his next step is completely random and has no connection to the step he just took. Proponents of this theory argue that the stock market behaves in a similar fashion. Today's price movement gives you absolutely no clue about tomorrow's. This concept is a cornerstone of the Efficient Market Hypothesis, which posits that all available information is already reflected in a stock's current price. Therefore, trying to predict future prices by analyzing past price charts (technical analysis) or even by scrutinizing a company's financial health (fundamental analysis) is a fool's errand. According to the theory, any outperformance of the market is due to pure luck, not skill.

If the Random Walk Theory is true, it has some pretty stark implications for investors. It suggests that a monkey throwing darts at a newspaper's stock listings could assemble a portfolio that would do just as well as one carefully selected by experts. Why? Because if all known information is already in the price, no amount of analysis can give you an edge. The next price move is a coin flip. This view directly challenges the livelihood of legions of professional stock pickers, chart analysts, and market forecasters. It suggests that the millions paid to fund managers are largely a waste of money, as they are unlikely to consistently beat a simple market average over the long run. The theory's logical conclusion for an investor is to stop trying to outsmart the market. Instead, you should simply aim to match the market's performance by buying and holding a diversified basket of stocks, perhaps through a low-cost index fund or ETF. This strategy, known as passive investing, accepts the “random walk” and seeks to ride the market's overall upward long-term trend without the fees and frustrations of trying to time it.

Hold on a minute, says the value investor. While the “drunkard's walk” is a compelling image for short-term market gyrations, it misses the bigger picture. Legendary investors like Warren Buffett, Peter Lynch, and the father of value investing himself, Benjamin Graham, have built careers and fortunes by consistently beating the market over decades—a statistical impossibility if the market were truly random. The value investing perspective argues that while the price of a stock might follow a random walk in the short term, its underlying value does not. Value is determined by a business's long-term earnings power, competitive advantages, and management quality. These are knowable factors that a diligent investor can analyze. Benjamin Graham introduced the perfect allegory for this: Mr. Market. Think of the market as your manic-depressive business partner. Some days he's euphoric and offers to buy your shares at ridiculously high prices. On other days, he's despondent and offers to sell you his shares for pennies on the dollar. His mood (the random walk) is unpredictable, but the underlying value of the business you co-own is not. A smart investor simply ignores Mr. Market's daily mood swings and instead uses his irrational offers to their advantage—buying when he's pessimistic (and prices are low) and perhaps selling when he's ecstatic (and prices are high).

So, where does this leave the ordinary investor? The Random Walk Theory provides a valuable lesson: don't get suckered into the game of short-term prediction.

• Don't be a day trader: Trying to guess the market's next move is a stressful and, for most people, unprofitable endeavor.
• Be skeptical of “hot tips” and complex charts: Past performance is no guarantee of future results, and patterns can be deceiving. The market's short-term noise is often random.
• Focus on what you can control: You can't control the market's daily walk, but you can control the price you pay for an asset. The core of value investing is not about predicting the stock price's next step but about calculating a business's intrinsic value and buying it with a margin of safety.

Ultimately, you can let the market's random walk work for you. When its chaotic stumble presents you with an opportunity to buy a wonderful business at a sensible price, you act. The rest of the time, you patiently hold, confident that in the long run, a company's true value will shine through, regardless of the random path its stock price took to get there.