Tuesday, November 15, 2005

what's a random walk?

Proverbs 12:11 He who works his land will have abundant food, but he who chases fantasies lacks judgment.

I just finished working on the initial draft of the handout for this Sunday’s class, Godly Wisdom for Managing Money. The session is about saving and investing. It is really a fun topic with a lot of counterintuitive results -- surprising stuff that twists up your preconceptions and otherwise messes with your mind.

I like that.

One result is that changes in stock market prices appear to be a random walk. What’s a random walk? Well as you might have noticed at the top of this page -- in big capital letters -- it is part of the title of this blog. In fact, the title of this blog is a play on words. Unfortunately, it is a play on words that only an economist would get. Double unfortunately for non-economists, like explaining a joke or like explaining any other play on words, if you have to explain so folks can get it, the it quickly becomes not worth getting.

The best predictor of tomorrow’s price of a stock, say a share of Microsoft Corp., is today’s share price. Why? Well, to put it simply, buyers and sellers have already incorporated all current information and all expectations about the future into today’s buying and selling. For example, suppose on Tuesday a lot of people knew (or thought they knew) that Microsoft stock was going to rise in price to $500 per share on Wednesday. That’s the word on the Street. Wouldn’t they be buying up shares on Tuesday before the price went up? Of course what will happen if lots of folks start buying up the stock on Tuesday is that the share price will rise on Tuesday.

So what will be Tuesday’s price of Microsoft? $500! People would keep buying and bidding up the price of Microsoft until there would be no expected profit to be made by buying one day rather than the next.

When Wednesday comes, Microsoft’s share price might go up again or even down from $500. However, any change would be the result of another reason – some news or other information not available Tuesday.

Wednesday’s news may be good or bad, but we don’t know what that news is on Tuesday. Any change would appear to be a random movement – a random walk -- from the price the day before. Of course, by Thursday we might have an explanation of what happened. But that won’t help anyone buying and selling two days earlier.


The implication is an important one. Unless you have some secret knowledge, unavailable to anyone else, any profits from speculating, from picking the right stocks which will go up in price, is going to be dumb luck. You win some, you lose some. It is random. If you get your news from the newspaper, it is probably too late to profit. Such information has already impacted the share price.

The lesson? Don’t waste your time speculating in individual stocks. You are just chasing fantasies.

Be blessed!

1 comment:

RB said...

I removed computer-generated "comments" advertizing other blogs. As a result I made "word verification" required to post a comment.