The Random Walk Theory – Why You Don’t Need a Stock Alert on your Phone

Information always makes for a better investor.  It is therefore important to be constantly watching your stock prices, checking for news, and being in constant contact with information.  You never know when a breaking news story will happen and you need to be ready to pull the trigger and buy a stock before it shoots up or sell a stock you own before it comes crashing down.  Everyone should have smart alerts set on their phone so that they can be ready no matter where they are, right?  Well, maybe not.  Here’s why.

There is a theory about investing called the Random Walk Theory.  This theory is described in the classic book, A Random Walk Down Wall Street by Burton Malkiel.  The Radom Walk Theory goes something like this:  Stocks are always priced perfectly for all existing news.  The instant a news story breaks, it is priced into the price of a stock.  Because of this, the price movements you see are just random.  You therefore cannot predict where stock prices will go in the short-term.

So, you own 200 shares of XYZ corporation that last traded at $100 per share.  Your phone goes off, saying that XYZ just had a dismal quarter, earning far less than analysts predicted.  You want to place a sell order immediately and get $100 per share before the price drops.

The trouble is that the other people who are thinking of buying the shares got the same alert.  The bid price (the price someone says they are willing to pay) instantly goes down to $90 per share to account for the reduced earnings.  Even though the stock traded at $100 per share just moments before, the best you can get for it now is $90.

This means that you will never be able to pounce on a stock like a panther just before it shoots up due to some good news.  Likewise, you’ll never be able to sell just before bad news breaks.  (This is unless you were a member of Congress before 2012, in which case you could trade a stock just before the committee you are working on makes a decision that will cause the stock to rise or fall.  Don’t ask me why this was legal, or even if it is now.)

So if you can’t trade on news, buying and selling stocks is just a crap shoot, right?  It’s all just random chance.  So what is the point of even trying to pick stocks?  Well, not quite.

While there is no reason to try to make money picking stocks for short-term trades, it is possible to beat the market by making long-term bets.  The reason is what is known as discounting for risk.  You see, everyone has the same predictions available on what they expect a company to earn a few years out.  But there is always a risk that the company will not make the earnings that are expected or be able to pay the dividend that is expected.  Because of this, stocks trade at a lower price – a discount – to what they would trade at if the company was certain to make the expected earnings.  The more uncertain the earnings, the greater the discount.

So, if you had company XYZ that had a 70% likelihood of making $1.00 per share (the probabilities here are just examples – you’ll never know the actual probability), the stock might trade at $90 per share.  If and when the company actually makes $1.00 per share, the price may then rise to $100 per share, resulting in about a 10% profit.  If company ABC is expected to make $1.00 per share, but with only a likelihood of 20%, it might trade at $80 per share.  If it makes earnings and the share price rises to $100, the investor would make a 25% profit.  A bigger potential return due to the increased risk.  The beauty of the market-based system is that you don’t need to calculate the risk discount yourself – the market does that for you since prices will naturally settle into a fair range for the given level of risk.

So, the way you make money is by finding companies that have growing earnings and holding them for long periods of time.  The more certain the earnings, the lower the return but the better the probability of making some return for a given stock.  The less certain the earnings, the greater the return due to the higher risk.

The strategy is to buy stocks with a little more risk, as shown by having a higher beta, but buying several different stocks so that for the ones that don’t work out you’ll have others that will and provide a large return.  (The beta is a measure of the volatility of a stock, which is related to risk.  A beta of 1.00 means the stock will rise 5% when the market rises 5%, and fall 5% when it falls 5%.  A higher beta means it will move around faster than the market.  A beta of 2.00, meaning the stock would rise or fall 20% when the market rose or fell 10%, would be very high.)

In general I look for stocks with a long history of growing earnings, lots of room for expansion, and little or no debt.  These are stocks that can be held for a long period of time as earnings grow.  They may miss earnings here and there, causing the price to decline for a period of time, but I know that over long periods of time these companies will grow and the price will increase.  In this way I don’t need to get the timing right – just the direction.  Believe it or not, this is not that difficult.

So, forget about phone alerts and trying to time the market.  Instead, look for long-term growth.  This is the key to beating the market.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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