Scientific Investing I: It is best to be a Random Walker!
Updated: Feb 18, 2022
When you are observing a drunkard or your 5-year-old toddler walking down a street, you cannot predict where his next step will exactly land. It could be on a crack in the road, it could be on a rock, and it could result in a tumultuous fall. This is Random Walk Theory. Just because you know how past steps fell does not imply that you have a good estimator about where the next couple of steps will fall. From Random Walk Theory’s initial start with Frenchman Louis Bachelier in 1900, to Paul Samuelson in the 1950s, and finally with author Burton Malkiel's famous book, Random Walk Theory has evolved and clearly shown how scientific investing is the only consistent way to make continuous market gains in a world where Random Walks do prevail. In Malkiel’s words, your results of a carefully selected portfolio of hand-picked securities are not better than “a portfolio assembled by a blindfolded monkey throwing darts at a newspaper’s financial papers”.
The idea behind Random Walk Theory arose with Louis Bachelier, a Parisian statistician and first to observe Random Walk behavior in stock prices during the year 1900. Through scientific analysis, Bachelier described his findings of market data as a random walk due to the fact that it is an unpredictable process in which changes in future stock prices are uncorrelated with past stock price changes. Therefore, future changes in market prices cannot be predicted, no matter how much effort one puts into trying to rely on past patterns. As unfortunate as this may seem, this actually makes total sense. If changes in stock prices could be predicted reliably, wouldn’t everyone outperform the market (which, of course in itself is not possible)? It would be like everybody being able to win the jackpot in every lottery going forward.
Within Bachelier’s ground-breaking work “Theory of Speculation”, he breaks down how investing in the market works. Bachelier notes that the speculation in the market is connected to future events—which are impossible to predict at any time. Basically, Bachelier highlights how much of a failing cause it is to attempt to predict the future of market movements. Even more to the investor’s chagrin, Bachelier illustrates that there is an equal likelihood of success and failure. In fact, he uncovered that you have a lower chance of succeeding in outperforming the market compared to flipping a coin, since investing in the market incurs costs which need to be overcome by betting on the correct side of future market movements (whereas a coin toss is free).
While Bachelier unearthed a sense of uncertainty in investing, Paul Samuelson drove it home by establishing that price fluctuations in the market are completely random. By contributing to Random Walk Theory in his article “Proof that Properly Anticipated Prices Fluctuate Randomly”, Samuelson reiterates that the market cannot be predicted and that there is no probability model in existence that can predict the movements of prices in the market—hammering the nail in the coffin to those who believe they have a crystal ball and can see the future of the market. Because of its unpredictability, the prices of the stock market, as Samuelson notes, is like a grouping of “uncorrelated or quasi-random walks”. The only pattern noted regarding prices in the market is that poor performance is more often than not followed by more poor performance—a pattern which you as an investor are probably not too excited about. Hence, Samuelson succeeds in showing would-be-investors clearly that there is no way to make a profit from using past price changes to predict future stock price movements. This may all appear very depressing to those who rely on stock picking as an investment strategy. Unfortunately, looking into the past cannot determine a company’s future, including stock chart analysis of past stock price movement. Therefore, you might as well use your collection of Technical Analysis Books as fuel for your next family barbecue.
Ultimately, Burton Malkiel contributes to the theory by boldly stating how “the psychology of speculation is a veritable theater of the absurd”. Using attention-grabbing analogies like monkeys throwing darts at financial pages to pick stocks, Malkiel enthusiastically explains the uselessness of even sophisticated analysis to predict future growth or future investment strategy. Thus, in the establishment of Random Walk Theory, the foundation of scientific investing is born. If you cannot predict the future of the market, what is the use of trying to stock pick and market time? The likelihood of success is so small and the amount of risk, costs, and loss is so high—why play a losing game? How can you escape this trap? The solution is this: evidence-based investing in low-cost index funds such as S&P 500 Index or ETFs from low-cost Index Fund and ETF providers. By academically investing in the broader market you embrace the randomness of the walk and don’t suffer from high fees. The only pitfall to watch out for is to stay within your risk profile and to stay the course of an academically clean investment portfolio through even the wildest market gyrations (more on this topic in future blog posts).