The Random Walk Theory of financial markets, originally advanced by Burton G. Malkiel in his 1973 book "A Random Walk Down Wall Street" states that the behaviour of the stock market is random, that is, the probability of the market going up or down in a given day is 50%. One of the implications of this theory is that over the longer run no individual investor can outperform or beat the market.
Before proceeding I should now explain what is meant by outperforming or beating the market. Suppose an investor has a capital of, say, US$100 thousand at the begining of the year and decides to invest that amount in a diversified portfolio that reproduces some major market index, such as the Nasdaq (or the Dow Jones, or the PSI-20, etc.). Suppose further that by the end of the year the index is up 20%. Then, our investor has made a return 20% on his capital. This is called a non-discretionary, passive, follow-the-market strategy.
Suppose, however, that our investor decides to follow an alternative, activist, discretionary strategy. By this it is meant that some days he invests his capital of US$100 in the Nasdaq, a few days later he desinvests it because, say, he fears the market will go down; he reinvests again some weeks later, etc. Furthermore, sometimes he invests long (betting the market is going up), other times he investes short (betting the market is going down) and he keeps doing this during the whole year. What the Random Walk Theory says is that with this activist, discretionary strategy he won't be able to earn more than 20% for the year, that is, he will not be able to achieve a return on his capital which is higher than the market return (+20%).
Put differently, the message of the Random Walk Theory to an individual investor or speculator is quite simple. It says that if you think that through your own personal, discretionary investment strategy you can make 25% on your capital in a period in which the market went up by just 20%, or that you can lose only 5% in a period in which the market fell by 10%, forget about it. You are wasting your time and your money. Not only you cannot beat the market using your activist, discretionary strategy, but the transaction costs (v.g., brokers' fees) associated with your frequent buying and selling of your portfolio during that period will most likely leave you with a return on your capital that is substantially below the market return.
Before proceeding I should now explain what is meant by outperforming or beating the market. Suppose an investor has a capital of, say, US$100 thousand at the begining of the year and decides to invest that amount in a diversified portfolio that reproduces some major market index, such as the Nasdaq (or the Dow Jones, or the PSI-20, etc.). Suppose further that by the end of the year the index is up 20%. Then, our investor has made a return 20% on his capital. This is called a non-discretionary, passive, follow-the-market strategy.
Suppose, however, that our investor decides to follow an alternative, activist, discretionary strategy. By this it is meant that some days he invests his capital of US$100 in the Nasdaq, a few days later he desinvests it because, say, he fears the market will go down; he reinvests again some weeks later, etc. Furthermore, sometimes he invests long (betting the market is going up), other times he investes short (betting the market is going down) and he keeps doing this during the whole year. What the Random Walk Theory says is that with this activist, discretionary strategy he won't be able to earn more than 20% for the year, that is, he will not be able to achieve a return on his capital which is higher than the market return (+20%).
Put differently, the message of the Random Walk Theory to an individual investor or speculator is quite simple. It says that if you think that through your own personal, discretionary investment strategy you can make 25% on your capital in a period in which the market went up by just 20%, or that you can lose only 5% in a period in which the market fell by 10%, forget about it. You are wasting your time and your money. Not only you cannot beat the market using your activist, discretionary strategy, but the transaction costs (v.g., brokers' fees) associated with your frequent buying and selling of your portfolio during that period will most likely leave you with a return on your capital that is substantially below the market return.
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