Random Walk Hypothesis - A Non-random Walk Hypothesis

A Non-random Walk Hypothesis

There are other economists, professors, and investors who believe that the market is predictable to some degree. These people believe that prices may move in trends and that the study of past prices can be used to forecast future price direction. There have been some economic studies that support this view, and a book has been written by two professors of economics that tries to prove the random walk hypothesis wrong.

Martin Weber, a leading researcher in behavioral finance, has performed many tests and studies on finding trends in the stock market. In one of his key studies, he observed the stock market for ten years. Throughout that period, he looked at the market prices for noticeable trends and found that stocks with high price increases in the first five years tended to become under-performers in the following five years. Weber and other believers in the non-random walk hypothesis cite this as a key contributor and contradictor to the random walk hypothesis.

Another test that Weber ran that contradicts the random walk hypothesis, was finding stocks that have had an upward revision for earnings outperform other stocks in the forthcoming six months. With this knowledge, investors can have an edge in predicting what stocks to pull out of the market and which stocks — the stocks with the upward revision — to leave in. Martin Weber’s studies detract from the random walk hypothesis, because according to Weber, there are trends and other tips to predicting the stock market.

Professors Andrew W. Lo and Archie Craig MacKinlay, professors of Finance at the MIT Sloan School of Management and the University of Pennsylvania, respectively, have also tried to prove the random walk theory wrong. They wrote the book A Non-Random Walk Down Wall Street, which goes through a number of tests and studies that try to prove there are trends in the stock market and that they are somewhat predictable.

They prove it with what is called the simple volatility-based specification test, which is an equation that states:

where

is the price of the stock at time t

is an arbitrary drift parameter

is a random disturbance term.

With this equation, they have been able to put in stock prices over the last number of years, and figure out the trends that have unfolded. They have found small incremental changes in the stocks throughout the years. Through these changes, Lo and MacKinlay believe that the stock market is predictable, thus contradicting the random walk hypothesis. Lo and MacKinlay have authored a paper, the Adaptive Market Hypothesis, which puts forth another way of looking at predictability of price changes.