Everyone would love to predict the movement of individual stocks.
The random walk hypothesis states that stock prices are random, like the steps taken by a drunk which would not follow a set path and, therefore, are unpredictable.
This was made popular in Burton Malkiel’s groundbreaking book – A Random Walk Down Wall Street, which was first published in 1973, the eleventh edition out this year.
Broadly, there are two approaches to predicting the movements of stocks: fundamental analysis and technical analysis.
Fundamental analysts believe the price of a stock is a function of its intrinsic value, which depends on the future earnings potential for a company. An analyst will decide whether or not to invest in a stock depending on whether it is trading above or below its intrinsic value.
By comparing a stock's price to its intrinsic value, the analyst can predict the potential future direction of the stock's price.
A technical analyst will forecast the future financial price movement based on an examination of the stock’s past price movements. It can help investors anticipate what is “likely” to happen to prices over time. A technical analyst will not attempt to measure a stock’s intrinsic value but will employ charts and other tools to suggest future movements.
The random walk hypothesis states that prices of stocks cannot be predicted as they change randomly. Hence it is impossible to predict stock prices. The chance of a stock's future price going up is the same as it going down.
Malkiel maintains that over a period of time, stock prices maintain an upward trend hence a long-term buy-and-hold strategy is the best and individuals should not attempt to time the market.
Long term stock prices will reflect performance of the company over time, but short term movements in prices can best be described as a random walk. Since the short-term movement of a stock is random, there is no sense in worrying about timing the market. A buy and hold strategy would be more effective.
The central message he has conveyed in all the editions of his book is that the investor who buys and holds a broadly based index fund, who effectively invests in the market as a whole, does better in the long run than all the stock pickers and Wall Street pundits.