Predicting Stock Prices & The Random Walk Theory
One of the most important & fundamental assumptions that Traders make is whether stock market prices are random or predictable. If you believe that high probability trades are possible, or that price movements are not random, then you can rely on your fundamental, technical and or quantitative analysis skills, to achieve greater returns than just investing in the overall market (Alpha). However, if you believe that prices can’t be predicted, then you should just invest in a good ETF for the S&P 500 like SPY and hope for a bull market.
Given the importance of this assumption it’s prudent to examine price predictability with a debate of the validity of the Random Walk Theory (or the Random Walk Hypothesis). The Random Walk Theory is a quantitative model of the stock market. It was laid out by Burton Malkiel, a Princeton economics professor. Random Walk theorists believe that securities prices evolve based on “a random walk” where there is no discernible trend. Prices essentially move randomly and independently of one another and therefore can’t be predicted through fundamental or technical analysis.
Like many theories that have gained support there may be some truth in it. There have been studies that show that picking stocks in a random fashion can perform as well as professional stock picking. In addition, professional stock pickers in general typically don’t outperform the market over the long term.
On the other hand, it is a fact that there many well-known individual and institutional traders such as Warren Buffett, Paul Tudor Jones, Stanley Drunkenmiller, George Soros and David Swensen (to name a few) consistently outperform the market average for long periods of time year in and year out. These Fundamental, Technical and Quant traders believe that price patterns exist that can be tracked both in the short term and even in the long term. Although even those Technical or Quantitative analysts who think that future price movements in the market can be predicted – don’t necessarily believe that they can infallibly predict future price action.
So, the reality then when it comes to price prediction is that both may be true in certain cases. It may be more accurate to say that within certain time frames price movement can be predicted more reliably than other timeframes; and that quantitative analysis of these probabilities can be a helpful tool to detect what these time periods are, and what these movements can be during these time periods.
As such it may be possible to generate higher returns by trading on price movements when adhering to an effective model versus just investing in the overall market.