The way of the market - random walk

Most investors will have heard the term 'random walk'. But, as with most catchphrases, it's an oversimplification. The idea originated with the work of the American academic Eugene Fama in the mid-1960s.

His notion was that markets tend to discount all available information and respond quickly to discount new information, so that any movements in prices over and above this are essentially random. Hence the thought that prices describe a so-called random walk around their correct value at any point in time. This is actually called 'the efficient markets hypothesis', but colloquially many investors have fixed on the randomness of price movements as the most significant aspect of it.

Let's look a bit closer and see what we mean in the case of an individual share.

In reality, the theory argues that competition between different players in the market means that prices react rationally and instantly to all known information about a share and the underlying company. Prices move to fit known economic fundamentals, a rational estimate of the future prospects for the individual company, and some form accepted trade-off between risk and expected return.

Theories and reality

This isn't just dry academic theory of no relevance. It's an idea that finds its way subconsciously into many investors' portfolios. If you think an index-tracker fund is a good home for your money, you are in effect subscribing to the efficient markets hypothesis and the idea of a random walk.

Attempting to beat the market over the long term is impossible without assuming significant additional risk. Many try, and pay the price. If you come to accept randomness, then the best strategy to adopt is a passive one, simply indexing your portfolio's performance to the market.

There are three forms of the efficient markets theory. These correspond to different ways in which the concept of 'available information' can be defined.

1. The 'weak' form of efficient markets hypothesis (EMH), suggests that past prices reflect all previously available information. Current and future prices may reflect information yet to be revealed.
   
   
2. The 'semi-strong' form of EMH suggests that markets reflect all publicly available information.
   
   
3. The 'strong' form of the theory suggests that prices reflect all the information that is publicly available or able to be acquired.

You could also add a fourth form of theory. This is subtly different. It would suggest that the market efficiently discounts perception of the meaning of available information. It goes without saying that sometimes perception can diverge from reality.

Fama has himself argued for a relatively loose interpretation of his ideas, saying only that markets are efficient only "for most investors, most of the time". EMH is regularly challenged by examples of investors who seem consistently to be able to beat the market. But examples like this are rare. Even gurus like Warren Buffet admit that opportunities are rare, and those who try to mimic them often fail. Buffet himself invests in very few stocks, suggesting that he too finds unearthing exceptions to the efficient markets rule very difficult indeed.

Yet exceptions there are.

Anomalies in the market can come about through technical imperfections that allow some investors to gain an information advantage over others. Or they can reflect the behavioural biases of some investors, whereby some astute investors may be able to take advantages of the temporary irrationality of a crowd of others.

Peter says

The more I have observed the markets over a career spanning over 35 years, the more I have come to the conclusion that attempting to beat the market by buying big, well-researched stocks is not really possible.

I acknowledge that the random walk idea and the efficient markets hypothesis for the most part makes a lot of sense. It's why a big chunk of my personal investment money is in index-tracking funds. I take the view that only in under-researched small companies can you find the information that leads to companies selling at the wrong price. Even then, the opportunities for gain without undue additional risk are not that plentiful.

One US fund manager, for example, observed that you have to respect the market like you respect the sea, because it's impossible to control. The market has no respect for any investor's status in life, length of experience, or previous track record. Be warned that it will humiliate those who think it should have.