The random walk theory maintains that individual stocks do not move in any discernible pattern. Therefore๊, their short-term future𒀰 movements cannot be predicted in advance.

Since the market indexes overall tend to rise over the long term, random walk theory would indicate that investing in a pa🤡ssively managed diversified index fund is the safest and most profitable investing strategy.

Followers of random walk theory reject the basic tenet of the investment management profession: That stock-picking is an art and a science that can lead to returns that exceed the market indexes.

Random walk theory is best represented by a contest regularly staged by The Wall Street Journal, in which professional stock pickers compete against investments selected by throwing darts at a stock table. The contest was held regularly for 14 years without conclusive results.

A new test has emerged in recent years, however. Highly sophisticated computer algorithms are being used to identify and exploit trends in stock prices. The trends they spot may last for fracti🌳ons of a second but their existence, no matte💙r how brief, would tend to overturn random walk theory.

Understanding Random Walk Theory

The theory and its name were popularized in a 1973 book, A Random Walk Down Wall Street, by Princeton economist Burton Malkiel. However, the concept was not⛦ new. In fact, it might be considered a third, a♈nd outlier, theory of stock-picking.

There are two main disciplines for professional stoc𓆏k pickers:ꦿ

• Fundamental analysis attempts to pinpoint a stock's intrinsic value by examining all financial data relevant to the company, its industry, and the economy as a whole.
• Technical analysis relies on historical price and volume data in an attempt to forecast the direction of a stock's price movements.

Random walk theory concludes that both of these disciplines are fruitless attempts to impose order on chaos.

Fundamental and Technical Analysis

The goal of both fundamental analysis and technical analysis is to pick stocks that outperform a specific market index or other benꦆchmark over time. Fundamental analysts study all of the financial data related to a company and its industry to find stocks that will have higher returns than the overall market. Technical analysts study the patterns of trading activity t🍸o forecast trends to pinpoint the correct time to buy and sell a stock.

Both fundamental and technical analysis are used by investment managers to buy and sell stocks in an attempt to outperform the market. Random walk theorists would argue that this addౠs risk without any likelihood of additional rewards.

The Bottom Line

Random walk theory maintains that changes in the stock market are unpredictable, lacking any pa🌼ttern that can be used by an investor to beat the overall market. This 🐷theory opposes both technical and fundamental analysis, which are used by investment managers to attempt to outperform the market.

According to the random walk theory, the best investment strategy would be to invest in a diversified index fund that is passively managed and represents the stock market as a whole. Because the market rises over time, this would generate the most reliable and profitable returns.