Collective Brain

Market Efficiency and Active Investing

Collective Brain

The stock market moves with new information. News is unpredictable and random; therefore, the stock market moves in an unpredictable and random way. The Random Walk Theory describes the way stock prices change unpredictably as a result of unexpected information appearing in the market. This "random walk" of changing prices has created a misconception among investors that stock prices change randomly for no rational reason. The news is random and unpredictable by nature. Investors react to the news, thereby effecting stock prices.

The year 2000 marked the centennial of the Random Walk Theory of stock market prices. Many scholars have confirmed and refined the research of Louis Bachelier, the hapless unsung hero of financial economics. On March 29, 1900, Bachelier presented "The Theory Of Speculation" as a thesis before the faculty of sciences at the Academy of Paris. He anticipated what was to become standard fare in financial theory: the random walk of financial market prices. One hundred years since the theory's conception, the vast majority of investors are still not convinced that the markets are random.

In 1964, MIT professor Paul Cootner published a 500-page book of reprints of all research on the randomness of the market. The book was titled, "The Random Character of Stock Market Prices." It contained the first full text English translation of Bachelier's 1900 thesis.

The Efficient Market Hypothesis explains the process of free and efficient financial markets. First, information about stocks is widely and inexpensively available to all investors. Second, all known and available information is already reflected in current stock prices. Third, the price of a stock agreed on by a buyer and a seller is the best estimate of the true value of that stock. Finally, stock prices change almost instantaneously as new unpredictable information appears in the market. All of these factors make it nearly impossible to capture returns in excess of a market return without taking greater than market levels of risk. As discussed in Step 8: Riskese™, the only issue of concern is the relationship between risk, return, time, and correlation.