Random Walk Hypothesis

The market is random and follows the random walk hypothesis. The random walk hypothesis is a financial theory stating that stock market prices take a random path and thus cannot be predicted. This is against the belief of technical analysts/chartists/technicians, fundamental analyst and money managers who often believes there are predictable patterns in the market and hence their believe contradicts the random walk hypothesis.

In no particular order or whatsoever (perhaps alphabetical), there are two commonly known groups of investors/traders in the market and they invest/trade in a different way.

Fundamental Analysis (FA): The first group of people practice fundamental analysis. People who practice fundamental analysis are known as fundamental analyst or long-term investors. This group of people makes use of past data of a company to predict the future price of the stock (contradicts the random walk hypothesis). They are thus, backward looking. Information helping them in their predictions includes the company’s income statement, balance sheet and cash flow.

Technical Analysis (TA): The second group of people practice technical analysis. People who practice technical analysis are known as technical analyst, chartist or technician. This group of people is also backward looking. They believe that the stock market price movement can be predicted using past patterns of charts or candlestick formations (contradicts the random walk hypothesis). Tools such as different indicators are used to help them in their prediction e.g. Fibonacci retracement, Stochastics, MACD etc. Other ways used to predict the future price of the market are different chart patterns e.g. Multiple top breakouts/breakdowns etc. And candlestick patterns e.g. Gravestone doji, bullish engulfing etc.

I do not believe either of the two. Believing the market is random contradicts the two common believes stated above.

In today’s (24 Nov 2013) The Sunday Times article published by Jonathan Kwok titled “I’m an investor, not a trader”, he classifies people in the market into two groups, those two that I mentioned earlier. I do not know this person or have anything against him, in fact, I always look forward to Sundays where I can read the invest section in the newspaper, then continue to see some fit and sexy individuals in the “Hot Bods” section under “Sports” But this article published was just misleading and stereotypical.

I will not go into the nitty gritty of the article, but two particular points stood out to me and it’s what I want to include in this post. First, it is wrong to classify people in the market into two groups, investors who use FA and traders who uses TA. Because I am a trader and I don’t use TA. Let me introduce another group of people in the market. This group of people does not have any fancy names that I know of, so I shall simply call them people who trade financial products.

People who trade financial products: People who trade financial products, I guess you can call traders, trade with probabilities and strategies. They do not believe that they know anything about the market, let alone predict where the market is heading. They hold the believe that the market is random (random walk hypothesis) and efficient (efficient market hypothesis). Which means that whoever thinks they know something in the market, it is probably information already reflected in the price of the market, giving them no edge or whatever. What they do is, they put on high probability strategic trades and allow the probability to work in their favor. This however, has to be done with a high number of occurrences because when the sample size is small, the probabilities may not reflect what it’s true value are.

“I’m an investor, not a trader” clearly left out this group of people who believes in the random walk hypothesis and the efficient market hypothesis. Just to be clear, I do not know if there is even more group of people out there in the market. But I belong to the third group.

The other point that stood out to me in the article was that the author (an investor) tried out on a paper money account some trades on currencies. On his first trade, the author “just followed the tips in one bank’s technical report, which I (he) received in my (his) work e-mail.” He first experienced some success before “things started souring”. He then went on to argue that trading is a zero sum game while investing with a buy and hold strategy isn’t. He even went as far as comparing trading to gambling, “placing a bet at the roulette table.” Gambling is about the casino having an edge over the people who places bets, just like the third group of people who trades financial products that put on high probability trades.

I would argue that the trade that he put on that turned sour in his forex experience is really a 50-50 shot. But this is already too long an article than I have initially planned. I shall continue with my writing on the Random Walk Hypothesis and Efficient Market Hypothesis in the upcoming posts, concepts that are proven and hence awarded Nobel Prize in Economic Sciences 2013. This is the philosophy and concept that the third group holds. This is also the lead up to the more complex options strategies that I informed my subscribers that I will write about. So if you are not a subscriber already, send me an email at neopokchow@gmail.com or alternatively, sign up for a copy of my free report below.

Thanks

Trader Pok

An Efficient Market Hypothesis and Random Walk Hypothesis believer.

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