The "random walk" theory states that since the stocks market is "efficient" there is no way to outperform....

Question

the market over the long term. Is that true and if not why?

Answer 1

The center of the idea is that the market, aggregate of financial actions by many with their several different purposes and intents, is not inherently knowable. To outperform the market assumes that you understand the market, when actually you are making assumptions, glorified guesses. If you are guessing, then the same limits that face a professional gambler come to play, unless you are cheating, no one person can always beat the casino, and no person could pass on how to "beat" the casino, or stock market.

Market "efficiency" is not quite the "efficiency" that the mechanical or chemical engineers talk of when they tweak their machines or processes to accomplish more of the intended end-product while using less external energy or fewer process steps. Market efficiency is more the "bubble" in the level, or a plumb line pointing down, than a "more horsepower with less fuel" problem. The market "efficiently" calculates comparative values as an aggregate representaion of the broader pool of investors.

The "random walk" gets its name from the only perspective a person has left, a chance shot, a path of progress that may or may not be profitable. Famous investment writers Graham and Bogel have both used "gamble" in their characterization of stock picking. Instead they look for intrinsic values or generalized trends to more reliably indicate positive investment directions over the long run. Then again, as Keynes so nicely reminded, "In the long run, we are all dead." Gamblers say that is when we "break even."

Part of the problem you may be struggling with is the definition of terms, confusing appearances with common perceptions. Some people do pick stocks and get fabulously wealthy. Just as Bogel was a fan of Graham, so is Buffet, and Buffet, unlike Bogel, is a stock picker. Now is where you need to rediscover another statistical phenomenon, it is called the "bell curve." The application is that you cannot be consistently, nor teach others to consistently, be too far beyond the standard deviation of the market's aggregate mean.

Answer 2

In an "efficient market" all things are known to all buyers and sellers.

The ASSUMPTION is:
all things are known to the market

The PRESUMPTION is:
the market will behave rationally to the facts.

If either of these is not true, the theory fails.


re: ASSUMPTION

Consider the "Enron debacle." Did the market know that Enron was cooking the books? Did the market know that the auditors were blessing the known fraudulent claims of the company? Did the market know that the CEO was dumping his stock while encouraging others to buy?

How could the market "efficiently" value the stock?

After Enron, when the SEC began investigating, MANY companies restated earnings for many previous YEARS! That means that LOTS of companies cook the books. Do you know which ones? or by how much the company overstates earnings, profits, etc?


re: PRESUMPTION

There are so many case studies on so many stocks where the conclusion is that the market is "punishing" a company by driving the price down too far when something "a little bit bad" occurs. The efficient market people talk about these events as "buying opportunities" ignoring the fact that any such "buying opportunity" disproves the theory.

Answer 3

That's not a fair representation of the random walk theory or the efficient market hypothesis (EMH). The hypothesis is that the current market price of a stock reflects on all known information on that stock. There are different versions of the efficient market hypothesis. In it's simplest form, the EMH states that past market movements of a stock cannot be used to predict future movements (i.e. "technical" trading doesn't work). Usually the theory is stated such as to claim that the market is efficient in the LONG RUN, not the short term. As such the theory is irrefutable. The theory also points out that 50% of the investors, by definition, do worse than the market average; therefore most folks are better off investing in index funds. Everybody on wall street is always bashing the EMH, because they perceive it, incorrectly, as threatening their livihood. But they always misrepresent it. Actually, if the market is efficient in the long run, and occassionally inefficient in the short run, it makes perfect sense to try to take advantage of those occassional inefficiencies, and profit from them. Some can do it, but many can't. And those that do can profit from those who don't. One can believe the EMH and still believe in trading individual stocks.

Answer 4

This is one of the most heated debates in the investment world. You can use historical data, but what index do you use? What timeframe do you use? How do you take risk into account? How do you differentiate dumb luck with actual stock picking skill?

Unfortunately, there is really no way of knowing exactly how efficient the markets are. Ironically, the more people that try to pick stocks, the more efficient the markets become... And vice versa.

Answer 5

I don't think the markets are perfectly efficient until everyone is perfectly (or at least identically) informed. Your average Joe doesn't have as good an understanding of the movements of the stock markets as say, a financial analyst. Therefore, some will perform better than the market average and some will fall short.

Answer 6

Well, most atheists will accept mathematical proofs as well, as any reasonable person would. That's not quite the same thing as scientific evidence. In mathematics, ideas can be proven; in science, by contrast, any hypotheses must be testable (and therefore subject to disproof, if the evidence indicates that such hypotheses are incorrect). Other than these two methods, I know of no good reason to accept a proposition. If the president, or the pope, or whomever, tells me that the moon is made of snow, for example, I'm still going to want to examine the evidence that supports this claim. Arguments from authority (which includes ancient texts, often called "holy books") are completely non-persuasive to me.

Answer 7

The Random Walk Hypothesis has never been proven. For example, there is clear daily price persistency, the property of markets to follow rising days with rising days (and falling days with falling days) in a non-random manner. In addition, markets trend (reportedly about thirty percent of the time. Trends are counter-random. Random Walk theorists claim that market prices do not have memories, however, investors and speculators do! As the market reacts to news, earning reports, economic conditions and the psychology of the investing public, supplu and demand conditions change as investors take action based on their 'previous' actions. Long holders with losses respond in predictable ways to price increases. Long holders with gains react in predictable ways to price declines. Areas of support and resistance develop around accumulation points. Initial Random Walk Theorists have reduced their claims of non-randomness and now embrace "the efficient market" theory. Yet, for the last 70 plus years, the markets have certainly exhibited a long term uptrend, coincident with the long terms economic uptrend. Apologists for the Random Walk Theory - Efficient Markets Hypothesis now acknowledge "randomness with drift". But the acknowledgment of "drift" is inconsistent with randomness.

I am a technical analyst and I consistently outperform the market with statistical and mathematical technical indicators, along with measurable fundamental factors. (I do not subscribe to the pattern and chart reading theories, which I believe are too subjective to be of use...or to the various cycle and wave theories in use, which, while experientially based, are also subject to subjective interpretation.)

The bottom line to your question is that the markets are not efficient. Markets are subject to the varying interpretations, errors, mis-calculations, non-financial considerations and other psychological bases of the daily actions of investors. Those who can correctly anticipate or identify the anomalies and divergencies in the market will always have an edge.

Answer 8

It is a widely accepted theory. And very few people have consistently outperformed the market - unless they have inside information, which might be illegal.

But there is some evidence that efficient markets theory is not always correct. So, while the theory is widely accepted, it is not universally accepted and it is not always correct.

Answer 9

It is not true........"Warren Buffet"......need I say more.......