First of all, what is a random walk? The classic description of a random walk is the scenario of a drunk man who starts off at a lamp post. Over time, as the drunk starts walking, his veering in random directions make him drift away from the lamp post. This scenario is also known as the drunkard’s walk. The idea illustrated here is that each time the drunk takes a step, he moves in a completely random direction from before.
Most economists and investors are acutely cognizant of the fact that high yield mutual funds, money market deposit accounts, and general security prices have erratic up-and-down movements from day to day. Furthermore, looking at security prices from hour to hour and minute to minute continue to show these fluctuations albeit at reduced magnitudes. These observations provided the basis for the idea that like the drunkard’s walk, stock prices move up and down and drift while adhering to strict statistical properties.
The usefulness of the random walk view point is largely mathematical. Should the price of a low risk investment obey a random walk, then it follows that the price should always move up and down around an average value. It should also follow that the deviations from the average value can never be too large, in fact, following a normal or Gaussian distribution. These observations surprisingly are true for many securities, at least on an intra-day basis.
In fact, the Black-Scholes theory of options pricing based on ideas drawn from random-walk mathematics was the reason for a Nobel Prize in economics. Readers will find the details of the theory daunting, but should keep in mind that it is no more than a formalization of the random walk idea.
While the success of the random walk theory is not arguable, the extent to which it is true is very much in contention. Instead of strictly fluctuating around a mean, many stock prices show “trending” or consistent movement up or down ove time. And instead of fluctuation, during stock market crashes, the price of stocks, bonds, mutual funds show precipitous declines. These inconsistencies have driven development of more accurate models but the issue is not resolved.
To the regular, layman investor who is engaged in low risk investments, mutual funds, and GNMA mutual funds over the long term, such information is not so useful for calculating returns and yields. On the other hand the veteran day trader who moves in and out of positions within hours may derive some value from these ideas.
Still have inquiries ? It might be worth it to check out our resources about the high yield mutual fund industry. Additional resources supplied for money market deposit account can be located here.
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