RANDOM WALK
The random walk theory is a theory that explains that "the movement of stock prices cannot be predicted." Simply put, no matter what has happened in the past, there is always a 5: 5 chance that tomorrow's market will go up or down.
The random walk theory is a concept in finance that suggests that stock prices follow a random and unpredictable pattern, making it difficult to predict future price movements. This theory is based on the idea that past market trends and performance are not reliable indicators of future market performance. Despite this, the theory of random walks does not mean that it is impossible to make a profit in the stock market, as the share price of a company is ultimately tied to its future performance and profitability.
In contrast to random walks, speculative trading involves aggressive buying and selling of stocks in order to generate a profit that exceeds the average market return. This often requires expert knowledge and analysis of market trends, but it can also involve significant risk. In contrast, passive investing aims to achieve returns that are in line with the market average, and this typically involves a more straightforward investment strategy, such as buying stocks in a market index.
The theory of random walks suggests that it is difficult for active traders to outperform passive investors, as the unpredictable nature of the stock market makes it difficult to consistently generate higher returns. To mitigate the impact of random walks, traders can focus on more predictable and liquid markets, trade in blue-chip stocks, follow market flows, trade based on news events, and trade during market openings or mid-day. However, even with these strategies, it is important to recognize that the stock market remains inherently unpredictable and that there is always some degree of risk involved in trading.
The theory of random walks has been widely researched by economists and financial researchers. One of the earliest and most influential proponents of the random walk theory was French mathematician Louis Bachelier, who published a PhD thesis on the subject in 1900. In the decades since, many economists and financial experts have conducted research on the random walk theory and its implications for financial markets. Some of the notable scientists and economists who have contributed to the research on random walks include Paul Samuelson, Eugene Fama, and Burton Malkiel. Today, the concept of random walks remains a central topic in the field of finance and continues to be studied by researchers in universities and financial institutions around the world.
Much less room for human judgment right?
So why can't active trading outperform passive investing? In active trading, the professional manager makes full use of theory and data to determine when to buy and when to sell. However, using the theory of random walks based on the theory of probability, it is impossible to predict the market price no matter which method is used. Sometimes it succeeds, and sometimes it does not, and the result is at the level of the market average. However, active trading is more expensive for managers and inventory analysis, so the results are worse than passive investing.
While the theory of random walks suggests that stock prices follow a random and unpredictable pattern, there are a few strategies that traders can use to mitigate the impact of random walks and potentially improve their returns:
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Trade only in liquid markets: Liquid markets are markets that have high trading volumes, which can make it easier to buy and sell stocks quickly and at reasonable prices.
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Focus on blue-chip stocks: Blue-chip stocks are stocks of well-established companies with a history of stability and steady growth, which may be less susceptible to the effects of random walks.
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Trade based on market flows: Monitoring market trends and flows can help traders to identify trends and make more informed trading decisions.
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Trade based on news events: Following news events related to the stock market and individual companies can help traders to stay informed about market conditions and make informed trading decisions.
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Trade during market openings or mid-day: Trading during these periods may offer more opportunities to trade and take advantage of market fluctuations.
It is important to note that while these strategies may help to reduce the impact of random walks, they are not guarantees of success and there is always some degree of risk involved in trading. Additionally, it is important to have a well-informed and diversified investment strategy in order to mitigate risk and achieve long-term success in the stock market.
