The Semi-strong and Strong Forms of the Random-Walk Theory

The Semi-strong and Strong Forms of the Random-Walk Theory

The academic community had rendered its judgment. Fundamental analysis is not better than technical analysis in enabling investors to capture above average returns. Nevertheless, given its propensity for splitting hairs, the academic community soon fell to quarreling over the precise definition of fundamental information. Some said it was what is knows now; others said it extended to the hereafter. It was at this point that what began as the strong form of the random-walk theory split into two. As we have seen, the “semi-strong” form says that no published information will help the analyst to select undervalued securities. The argument here is that the structure of market prices already takes into account any public information that may be contained in balance sheets, income statements, dividend declarations, etc.: professional analyses of these data will at best be useless. The “strong” form says that absolutely nothing that is known or even knowable about a company will benefit the fundamental analyst. Not only all the news that is public but also all the information that it is possible to know about the company has already been reflected in the price of the stock. According to the strong frm of the theory not even “inside” information can help the investors.

The basic problem, both forms of the theory say, is that security analysts are very good at interpreting whatever new information does become available and acting on it quickly. Information is disseminated rapidly today, and it gets reflected almost immediately in market prices. The fact that they all react so quickly makes it extremely difficult for the analysts to realize a significant profit in the stock market on the basis of fundamental analysis.” (It might actually be very inconvenient for professional analysts if it could be shown that they did get above average returns. This would imply that some other group (presumably the public) was earning below-average returns. Think of the reformers who would press to restrict the pros » activities so as to protect the public).

The 4 Directions Garden. This circular garden's design is based on aboriginal medicine wheels and is arranged around the four cardinal compass points. It contains the food plants known as the Three Sisters, which are corn, beans and squash. As well, there are traditional medicinal plants including Pearly Everlasting (Anaphalis margaritacea), Wild Bergamot (Monarda fistulosa) and Purple Coneflower (Echinacea purpurea). In the east and west, sacred Sweetgrass (Hierochloe odorata) is planted to mreind us of the sweetness of life and respect for the Earth and all that it provides. Photo by Elena

Nobel laureate Paul Samuelson sums up the situation as follows:

If intelligent people are constantly shopping around for good value, selling those stocks they thing will turn out to be overvalued and buying those they expect are now undervalued, the result of this action by intelligent investors will be to have existing stock prices already have discounted in them an allowance for their future prospects. Hence, to the passive investor, who does not himself search out for under- and over-valued situations, there will be presented a pattern of stock prices that makes one stock about as good or bad a buy as another. To that passive investor, chance alone would be as good a method of selection as anything else.

This is a statement of the random-walk, or efficient-market theory. The “narrow” (weak) form of the theory says that technical analysis – looking at past stock prices – could not help investors. The “broad” (semi-strong and strong) forms state that fundamental analysis is not helpful either: All that is known concerning the expected growth of the company’s earnings and dividends, all of the possible favorable and unfavorable developments affecting the company that might be studied by the fundamental analyst, is already reflected in the price of the company’s stock. Thus throwing darts at the financial page will produce a portfolio that can be expected to do as well as any managed by professional security analysts. In a nutshell, the broad form of the random-walk theory states:

Fundamental analysis cannot produce investment recommendations that will enable an investor consistently to outperform a buy-and-hold strategy in managing a portfolio.

The random-alk theory does not, as some critics have proclaimed. State that stock prices move aimlessly and erratically and are insensitive to changes in fundamental information. On the contrary, the point of the random-alk theory is just the opposite: The market is so efficient – prices move so quickly when new information does arise – that no one can consistently buy or sell quickly enough to benefit.

Even the legendary Benjamin Graham, heralded as the father of fundamental security analysis, reluctantly came to the conclusion that fundamental security analysis could no longer be counted on to produce superior investment returns. Shortly before he died in 1976, he was quoted in an interview in the Financial Analysts Journal as follows:

“… I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd as first published; but the situation has changed… I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost… I’m on the side of the “efficient market” school of thought…”

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.