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In 1973 a renowned Princeton professor, Burton Malkiel, published his bestseller A Random Walk Down Wall Street, and the book was reprinted seven times in 25 years. His thesis is as follows. Today’s stock market is so efficient that a blindfolded chimpanzee aiming darts at the stock price pages of the Wall Street Journal could select a stock portfolio that would perform just as well as a fund actively managed by a professional broker. It was Malkiel who popularized the notion of the random walk of stock prices, an idea that owed its inception to Louis Bachelier 80 years earlier.
That said, such an analysis is valid only when applied to a sizable number of stocks, as is the case with the Standard and Poor’s 500-stock index, the gauge that Wall Street uses to track stock performance and for which a portfolio is composed, by definition, of 500 stocks. Curiously enough, it was only in 1952, as we saw earlier, that Harry Markowitz based his reasoning on a portfolio of securities rather than holdings taken one by one. His seminal article that opened the way for the random walk is soberly entitled ‘‘Portfolio selection’’. His aim was to formulate rules of portfolio construction for investors who find expected returns desirable and variance of return (a concept not unrelated to standard deviation, as we saw earlier) undesirable.
The random walk notion may also indicate that it suffices to invest in the stock market and ‘‘go with the flow’’ in order to achieve reasonable monthly gains at least equivalent to the average monthly performance of the index over the most recent 10 years. If one is convinced that ultimately the future will resemble the past and that prices will continue to follow the same law of probability, it stands to reason that average future performances should be altogether comparable to those of the past. As measured in terms of standard deviation, price volatility should likewise be based on long-standing precedents. In fact, shareholder return for a portfolio randomly varies according to a distribution that appears similar to a normal law. From a statistician’s point of view, observation of real profitability rates may be interpreted as a random evocation of a law of probability. If one postulates that the former randomly fluctuates, then past sequences may indeed be interpreted as samples of the law of probability for shareholder return on the portfolio. And if price variations indeed manifest themselves totally at random, past distributions may be used not only in hindsight, but also as a means of accurately forecasting.
Let’ s take as an example the Paris Bourse at the start of the twenty-first century. If monthly price changes are randomly distributed, there is a 68 percent chance that they will vary by no less than – 4.9 percent in any one month or by no more than + 6.6 percent. Since 68 percent represents approximately two-thirds, this means that in two out of every three months, these changes will neither exceed 6.6 percent nor dip under – 4.9 percent. The law of probability does not indicate which rate will be attained, nor does it indicate when. All it does is to specify the percentage chances of profitability’ s reaching the designated level.
A random walk does not mean that stock prices evolve haphazardly as if basic information did not exist. Quite the contrary, a random walk constantly draws on incoming data. The market is exceedingly efficient. Prices go up and down as news and information come in. Nobody is in a position to draw profit on a preliminary basis. Nobody can satisfactorily forecast the upcoming market evolution. It was Bachelier himself who wrote in his 1900 doctoral dissertation: ‘‘The mathematical expectancy of the speculator is zero.’’ When the market is characterized as efficient, this means that no investor can make a lifelong living out of beating the market at its own game. Not a single soul can repeatedly and systematically do it. Markets vary at random. The mathematical expectancy cannot possibly be higher than the indexed average. Speculators think and believe otherwise; their expectation is that they will outdo the market. We might say that they anticipate and draw profit from tomorrow’s news. Bernard Baruch appositely wrote: ‘‘A speculator is a man who observes the future, and acts before it happens.’’ Any investor is a speculator in so far as, seeking to foresee, he or she bets. When doing so, investors may exert influence on prices, which reflect the expectations engendered by the news. And yet what was anticipated does not necessarily come into being; quite the contrary. Even if the speculator was not mistaken concerning the repercussions of the news, more recent events may have affected prices by the time of resale. It is highly likely that the speculator will not outperform the market; in fact his mathematical expectancy is zero. And yet he still hopes and strives to buck the odds.