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STOCK PRICE FOLLOW A RANDOM WALK AND THE STOCK PRICES FOLLOW A RANDOM WALK IF ALL INVESTORS

Introduction

Companies that pay dividends reward investors with both income and potential stock appreciation over time. (Williams, Clinton 2001:102)The dividends received from stocks are usually less than the coupon payments from bonds, but the potential price appreciation is much greater with stocks, thus setting up the classic trade-off between fixed income and equity investments. Although a precise formulation of an empirically refutable efficient markets hypothesis must obviously be model-specific, historically the majority of such tests have focused on the forecastability of common stock returns . (Pesaran, Timmermann 2004:1201)Within this paradigm, which has been broadly categorized as the random walk theory of stock prices, few studies have been able to reject the random walk model statistically.

Discussion

However, several recent papers have uncovered empirical evidence which suggests that stock returns contain predictable components. For example, Keim and Stambaugh (1986) find statistically significant predictability in stock prices by using forecasts based on certain predetermined variables.

If stock markets are weak form efficient, stock prices are said to follow a random walk. The random-walk hypothesis states that price changes in stock prices are unpredictable. The information contained in past prices is fully and instantaneously reflected in current prices in an efficient market. Hence, the opportunity for any abnormal gain on the basis of the information contained in historical prices is eliminated. Studies of stock price behaviour in the developing economies can be found in Magnusson and Wydick (2002), Chiang, Yang and Wang (2000) and Alam Hasan and Kadapakkam (1999). (Mladjenovic 2009: 153)The results have been mixed. Magnusson and Wydick (2000) test the random walk hypothesis for a group of African countries and find that there is a greater degree of support for the African stock markets than for other emerging stock markets. Chian, Yan and Wang (2000) analyzing stock returns in a group of Asian economies find that most markets exhibit an autoregressive process rejecting the random walk hypothesis. Alam, Hasan and Kadapakkam (1999) test the random walk hypothesis for Bangladesh, Hong Kong, Sri Lanka and Taiwan. They find that all the stock indices except the Sri Lankan stock index follow a random walk. This study on the contrary, supports the random walk hypothesis for all four countries studied.

People who believe in an efficient market generally also believe that stock prices follow a random walk. It can hardly be that both concepts apply (at least not at the same time), can it? These are opposite sorts of phenomena. An efficient market is one in which prices are in some important sense “right.” For prices to be right, they would need to be set by some rational process. Things set by a rational process are not random; they are predictable(Brealey, Myers 2003:67).

Mathematics is rational. The results of mathematical calculations are not random.

If you are trying to drive your car in such a way as to make efficient use of your fuel, you do not choose your driving speeds ...