Are we all fooled by randomness? The random walk trading strategy will answer this question. Throughout this trading guide, we’ll attempt to answer what is random walk theory and learn how to trade the stock market without technical analysis or fundamental analysis.
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The famous book A Random Walk Down Wall Street by Burton Gordon Malkiel had an explosive contribution to the random walk model economics. Malkiel is not a friend of technical analysis as he believed that traders can’t predict what will happen in the future.
Likewise, the random walk hypothesis has been connected to the efficient market hypothesis (EMH) because both theories claim that it’s difficult for most stock traders to systematically beat the market.
Let’s get the ball rolling by first answering, what is random walk theory?
What is Random Walk Theory
The random walk theory also known as the random walk hypothesis is a financial model which implies that there is no degree of predictability in the movement of stock prices. In other words, the random walk method assumes that stock prices are random thus using historical prices to forecast future price movements is futile.
By contrast, the efficient market hypothesis claims that the current price reflects the company’s intrinsic value as all available information is already factored into the price.
If the random walk model economics really works then this means that all trading strategies and the art of technical analysis will fail in the long run. Everyone who has been using technical analysis knows this is not true.
Now, the question we really need to answer is:
“Do stock prices follow a random walk?”
Right off the bat, if you look at the S&P 500 chart in the last 10 years we can clearly spot a pattern.
See how to trade the S&P 500 index here: S&P Trading Strategy – The 3 bar Strategy.
The main pattern noticed is that the stock market has the tendency to go up over the long run despite the constant ebb and flow of the price.
Burton G. Malkiel's interpretation of this chart is that similar to what happened in the stock market can be created by a coin toss (see chart below). The conclusion is that there is no predictability in what will happen next.
A pattern created by a coin toss. Source: A Random Walk Down Wall Street: The Time-Tested Strategy for Successful
Let’s see how random walk investing is supposed to work.
How the Random Walk Theory Works
Let’s consider the example below:
A stock investor analyzes the historical price of the company XYZ and now is expecting that the share price will rise. The investor proceeds forward and buys the share of company XYZ but the share prices started to decrease in the following months.
So, the theory is that there is no relationship between the current stock price or the past price data and the future stock price.
If today the stock price is $20 per share, the stock can be trading tomorrow at $30 or $10 per share and there is no relationship between these prices.
The random walk investment strategy assumes if there is a 50% probability that the stock price will rise then there is a 50% probability that the stock price will fall.
Now, if you have been trading the stock market for a while, the above statement can easily be proven wrong. We have proof that the random walk hypothesis is not true.
Stock prices are not really random walks because there are some patterns that you might observe, and optimization that you can do to stack the odds in your favor.
This raises an important question:
What is the relevance of random walk investing?
What is the Relevance of Random Walk Theory
According to a random walk, stocks can’t be traded profitably other than by share chance.
Let’s talk about this from a pragmatic point of view.
As the name suggests the random walk hypothesis is simply a theory that is only discussed in academic writings. But like with other things in life, there is a gap between theory and real-life trading.
You can use a random walk algorithm and pretend you have generated a random chart. However, even within that “random series” we can spot trading chart patterns.
So, even computer-generated random graphs aren’t actually random.
They can follow subtle patterns that with a trained eye can be noticed over the long run.
Let’s explore some of the reasons some traders are skeptical of technical analysis.
Does Technical Analysis Really Work?
Yes, technical analysis works as many professional traders swear by it.
Marty Schwartz aka the Pitbull guy aka the market wizard technician has this to say about the efficacity of technical analysis:
“I used fundamentals for nine years and got rich as a technician”
Schwartz turned a small trading account into a multi-million dollar fortune so he must know a thing or two about why the random walk hypothesis is wrong.
So, what are the main reasons traders bring against technical analysis:
- First, traders disregard steps to technical analysis because they wrongly assume big institutions only rely on fundamentals.
- Technical analysis can be biased and open to interpretation.
- Technical analysis is a moving target.
- A quant is better than a technician.
- The base of technical analysis uses inconsistent analytical systems.
In large, these are the most common reasons why traders are skeptical about technical analysis.
Let’s discuss how the random walk trading strategy works in practical terms.
Random Walk Trading Strategy
The random walk trading strategy does one thing that neither fundamental nor technical analysis can really assert. Random walk trading can predict really reasonably how the stock market is going to look in 5, 10, or 20 years.
The random walk theory asserts that overall you’re going to see an increase of about 10% over the long run. However, on a year-to-year basis, the stock price is going to fluctuate back and forth.
The stock market can go up 25%
Or, it can go down 15%.
But generally speaking, all of these numbers are going to equal out over a 40, 50, and 100-year span.
If you put all your eggs in one basket, you’re risking all of your hard-earned cash on that single stock.
Check if it’s profitable to trade only one stock all the time here: How to Get Rich From Single Stock Trading?
Now, if the stock of the company you’ve invested in drops 20%, you’re losing 20%.
On the other hand, if the stock you have invested grows 20%, you’re going to earn 20%.
Overall, your gains or losses are tight to one particular stock.
The random walk trading strategy demands to spread out your risk to a bunch of different stocks instead of putting all your risk into a single stock.
This way if one stock performs poorly, another stock might counteract that and perform better. Or, at the very least you’re going to be able to lose less.
If you diversify your stock holdings into a variety of stocks, the random walk theory says that this will yield a higher return.
Now you might be wondering:
How can I diversify my portfolio?
#1 Invest in an Index ETF
An easy rule of thumb is to keep things simple.
In this regard, a simple way to achieve diversification is to buy into an index fund.
Essentially, an index fund takes your money and spreads it out across a shared reasonable portfolio of the entire market. This way your money is well diversified.
The most popular index funds are:
- Fidelity ZERO Large Cap Index (FNILX).
- SPDR S&P 500 ETF Trust (SPY).
- iShares Core S&P 500 ETF (IVV).
- Invesco QQQ ETF (QQQ).
To lose all of your money, the entire market would need to crash. And, realistically, the likelihood of the entire market crashing is much lower than the risk of a single stock crash. Learn how to trade stocks in a recession.
You can not only invest in ETFs, but these instruments are acceptable for day trading as well due to their volatility.
Check out our guide if you’re interested in how to day trade ETFs.
Stock traders can also build up their own diversified portfolios. In this regard, we’re going to give you some tips on how to diversify stocks.
How to Do a Perfectly Diversified Stock Portfolio
The main idea behind diversification is to keep your investment portfolio safe even if the stock market crashes. If we can achieve this then our stock portfolio is likely to grow faster and help us get closer to being financially independent.
There are many different ways to diversify a stock portfolio.
This means that not all diversifications are created the same.
To diversify your stock portfolio more perfectly, you need the stocks to have a lower correlation to your portfolio. In theory, the lower the correlation, the safer our portfolio becomes.
Secondly, you need a plan to build a diversified stock portfolio.
We’re going to lay down a beginner’s guide for how to diversify your portfolio.
Here’s how to diversify your stock portfolio (a 7-step guide):
- Step #1: Buy at least 10 stocks across various sectors.
- Step #2: Diversify with dividend-paying stock – they are a true form of passive income.
- Step #3: Rebalance your portfolio frequently.
- Step #4: Define your risk tolerance.
- Step #5: Invest in consumer staple stocks.
- Step #6: Pick stocks with different rates of returns.
- Step #7: Invest in different asset classes (bonds, real estate, crypto, cash, and international investments).
A big mistake stock investors can make is to go over the board and diversify across 20-40 stocks. The big issue with this approach is that it will dilute the best returns that you hope to achieve with the best stocks.
Note* Staple stocks are companies that are always in demand. Staple stocks include companies that produce household goods, cleaning and personal hygiene products, food, beverages, and other products.
Final Words – Random Walk Hypothesis
In summary, the crux of the random walk trading strategy is that the past price data cannot be used to predict the future share price of a stock. Trading based on the random walk theory is not a get-rich-quick scheme, this is a long tedious way to make money in the stock market.
So here is a quick summary of what you’ve learned today:
- The random walk hypothesis is just a theory.
- The stock market is not random because we can see a recurrent pattern.
- Technical analysis works.
- Diversification is at the base of the random walk trading strategy.
- How to Do a Perfectly Diversified Stock Portfolio.
Thank you for reading!
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