I realized that I’ve been taking some ignorant swings at “Random Walk” and the Efficient Market Hypothesis.  I hadn’t really read anything related to random-walk since Economics 101.  This realization, coupled with the fact that I literally live in the shadow of a wonderful public library that I have NEVER used, led me to take the short, direct walk to the library to get the book and review it.

All in all, the book is a good read and a valuable read in the sense that stock investors who take its recommendations to heart are far less likely to shoot themselves in the foot by overtrading, chasing performance, etc.

The basic premise of the book is that price movements in the stock market resemble a random walk, and that past price movements are not predictive of future price movements.  The book does make passing mention of a LONG TERM UP TREND in equity prices roughly equivalent to the long run rate of earnings growth, but rather curtly declares that transaction costs are prohibitively high, and therefore, short-term trend trading is not superior to a buy and hold approach.  In fact, it categorically goes through most widely followed methods of stock picking and explains why these are inferior to index investing.

Get it?  Two things : Future stock prices cannot be predicted, and nothing beats buying and holding a diversified portfolio that is primarily made up of US stock index funds.

Here are some important limitations to consider, however.

The conclusions about efficient pricing and long term upward bias apply to the STOCK MARKET ONLY.  Furthermore, while the book explains why fundamental and technical analysis “do not work”, it pre-supposes that an inability to predict the future movements of stock prices necessarily means that one should not be able to outperform the market over a long period of time.  Keep in mind that the book had already acknowledged the inconvenient trend phenomenon but managed to “normalize” it away.

My own evolution as a trader has taken me away from active stock investing.  In fact, the relatively small percentage of my assets that are currently held in stock funds are actually invested in index funds.  Why?  The risk-reward relationship for successful stock picking is relatively small due to the high costs and/or inavailability of high degrees of leverage.  I personally find my skill set more suited for forex trading, but this is by no means a recommendation that everyone run out and start changing their dollars for euros and pounds and whatnot.  Forex trading is purely speculative, and speculation and investing are really two entirely different animals.  Month after month, my forex trading results are convincing me that speculative, short term trend following in the forex market can and does produce returns that are not only outstanding, but also uncorrelated to the returns in my stock portfolio.  This is diversification at its best. 

Despite my rather facetious rant against index funds in a prior post, the vast majority of us will be investing in stock funds via tax advantaged accounts like IRAs and 401k’s…for this purpose, Random Walk’s advice is practical, easy to implement, and perhaps the best way to get rich slowly and enjoy a financially free future.