Random Walk Theory: Refutation and Alternative Theory

Burton G. Malkiel's Random Walk TheoryThe theory of the random walk is one of the ways of understanding the behavior of financial markets in general and the stock market in particular that have been most accepted in the academic field. As we will see, despite its supposed success, this theory is far from explaining the behavior of the markets from a realistic point of view. In this article I will explain what the random walk theory consists of and we will see its uselessness in practice together with a more suitable alternative to understand the functioning of financial markets.

Explanation of Burton G. Malkiel's Random Walk Theory

The random walk theory was formulated by value investing and the doctrine of Benjamin Graham, show the theory of the random walk demonstrating that it is not the most appropriate in real life, far from the academic field.

The best way to demonstrate the invalidity of the random walk theory is by showing that there are people who are capable of consistently outperforming the market. Warren Buffett published on May 17, 1.984 (just 2 days after my birth) an article called “The Superinvestors of Graham-and-Doddsville”In which he dismantled the theory of the random walk and efficient markets by reducing it to the absurd. If the markets were efficient and followed a random path, it would be impossible for the followers of Graham and Dodd to be able to outperform the market continuously for decades.

I recommend you read the entire article, as it is very worthwhile. The best phrase that sums up Buffett's criticism of the theory of random walk and efficient markets is the following:

"If the markets were efficient, I would be on the street right now asking for alms"

Today, even Professor Malkiel, the author of this theory, has had to admit that some markets are not efficient and follow a non-random path.

The market does not have a random behavior, at least in the long term

As we have already seen, the random walk theory is not the most appropriate as a theoretical framework that serves to explain the behavior of financial markets. The best alternative to the random walk theory is the allegory of Mister Market, which I told you about on the blog. This theory was put forward by Benjamin Graham in the book “Recommended books to learn to invest in the stock market.

Here is my little summary about the allegory of Mister Market:

Mister Market is an investor, a shareholder in many companies, who buys and sells shares on a daily basis. The problem with the protagonist of this story is that he suffers from bipolar disorder, also known as manic-depressive psychosis. This disease has the consequence that Mr. Market has sudden mood swings that affect the way he deals with his shares.

Some days you wake up very happy and optimistic, so you buy stocks at very high prices, while on others you are depressed and excessively pessimistic, selling your shares at very low prices. These mood swings can last for days, months, or even years, but in the long run you always have some period when you return to normal and come to your senses.

In conclusion, don't be fooled. Financial markets are neither efficient nor follow a random path. Beating the market consistently is possible if we follow the teachings of Graham, that is, if we follow the doctrine of value investing.