Random walk Hypothesis
This theory defends that future price movements in the stock market cannot be predicted, and beat the market in the long-term.
According to this theory, the great majority of fund managers who try to invest in stocks actively will underperform the return of the main stock indexes.
From this point of view, technical and fundamental analysis are worthless. And, a blind monkey throwing darts will have the same chance of success than any active fund manager.
The main proponent of this theory is Burton Malkiel. He wrote, what is, one of the most famous stock market books ever: A random walk down Wall Street.
Malkiel´s book is one of the best that has been written about the financial markets and stock investing, whether the theory is correct or not.
It is one of the most complete books about investing, and contains all kinds of useful advises and stories.
Random walk market efficiency
The book could be considered an investing guide using random walk hypothesis.
The basic recommendation of the book is that investors should not waste their time trying to beat the markets buying and selling stocks depending on the fashion of the day.
According to Malkiel, the best an investor can do is to buy funds or etfs reflecting the main index – normally the SP500 – and maintain them for the long-term.
He presents all sorts of data supporting his claims.
For instance, the majority of American funds underperformed the SP500 the last 50 years.
The truth is that Malkiel´s ideas are correct and false at the same time.
Burton Malkiel investing
It is true that the great majority of fund managers have performed worse than the SP500 in the long-term. It is true that an individual should probably try this strategy for his investments.
It is true that buying the most successful funds of any moment is not a good idea (1).
It is, also, true that the majority of traders who try technical analysis or day trading will fail. Quite often they will lose all.
However, if the main advice is correct, that does not mean that the markets are random.
What is random is something like day trading, or trying investing in the fashions of the day.
The case about day trading, is where the random component is strongest. That business is purely made for dealers.
Investing vs speculating
What we have to do is to distinguish between speculation and investing, and between speculators.
We can be sure than Michael Marcus, Tudor Jones, Kovner and Seykota irrefutably prove that there is a way to beat the market consistently. But we have to remember some things: That is not investing in stocks, neither is something that anybody can do, but just a minority.
With respect to investing, there are proponents of the value investing theory of Graham, like Warren Buffett.
According to those, it is possible to beat the markets using a correct selection of stocks for the long-term.
It is possible that they are right, but in essence, Malkiel´s idea will still be correct. Those who can beat the market using “value investing”, will be a tiny minority.
Most investors who try to do so will fail.
One of the most interesting facts in the book is that small cap stocks tend to perform better than the overall market in the long-term.
Random walk stocks
But we should not forget that their beta is quite bigger.
The possibility for a small cap to rise 5000% is greater than it is done by a blue chip and yet we must not forget that the possibility of losing 100% is also bigger.
I have already talked about the fact that markets are not really random.
Random walk cycle
The eventual behavior of the stock market is not the same as throwing dices.
Markets are influenced by human action and praxeology (2). Like any student of the latter should know, markets are not random, but like human nature: cyclical.
Mass psychology has nothing to do with dices.
When you roll a die, the probability to get a one is 1/6.
When you start imposing price controls in a society, the probability for an increase in inflation is 100%.
That is not random.
The tendency for stocks to rise during the capitalistic era is predictable. But, it is also predictable that that tendency will reverse one day.
Investing cycles, if true for the “long-term” cannot escape the cycles of life.
- This is because when people buy the best performing funds, it is usual that those funds stop being the best after a while. Everybody is attracted to the higher returns. For instance, everybody was tempted to buy banking sector funds in 2007 because their returns had been fantastic the previous four years. However, those funds collapsed completely thereafter.
- The works of Von Mises are a must-read.