Theory of Random Walks: Predicting Stock Market Prices

Topics: Stock market, Technical analysis, Share price Pages: 3 (808 words) Published: June 12, 2010
Random Walks in Stock Market Prices
FOR MANY YEARS economists, statisticians, and teach-
ers of finance have been interested in developing and testing models of stock price behavior. One important model that has evolved from this research is the theory of random walks. This theory casts serious doubt on many other methods for describing and predicting stock price behavior methods that have considerable popularity outside the academic world. For example, we shall see later that if the random walk theory is an accurate description of reality, then the various "technical" or "chartist" procedures for pre- dicting stock prices are completely without value. -

In general the theory of random walks raises chal- lenging questions for anyone who has more than a passing interest in understanding the behavior of stock prices. Unfortunately, however, most discussions of the theory have appeared in technical academic journals and in a form which the non-mathematician would usually find incomprehensible. This article describes, briefly and simply, the theory of random walks and some of the important issues it raises concerning the work of market analysts. To preserve brevity some aspects of the theory and its implications are omitted. More complete (and also more technical) discussions of the theory of random walks are available elsewhere; hopefully the introduction provided here will encourage the reader to examine one of the more rigorous and lengthy works listed at the end of this article. Common Techniques for Predicting Stock Market Prices

In order to put the theory of random walks into perspective we first discuss, in brief and general terms, the two approaches to predicting stock prices that are commonly espoused by market professionals. These are ( 1 ) "chartist" or "technical" theories and (2) the theory of fundamental or intrinsic value analysis. The basic assumption of all the chartist or technical theories is that history tends to repeat itself,...
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