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Is the Stock Market Random?

Original post by David Sarokin of Demand Media

Stock prices follow regular and predictable patterns -- unless they don't.

If the stock market was entirely predictable then every investor would know what next week's -- or next year's -- stock values would be and could invest accordingly. No one would lose money. Stocks don't act with perfect predictability, of course, but neither are they entirely random. Stock prices react to combinations of events, some of which are more easily anticipated than others.

Random Event

An event is random if its future state cannot be predicted. The movement of the tides is not random, as it's possible to predict high or low tides far into the future. The toss of a coin is a random event, as there is no way to predict if a future toss will result in a heads or tails. Random events, although they cannot be predicted, can have an associated probability. For example, in tossing a pair of dice, the outcome cannot be known, but it is much more likely to toss a seven than a two.

Random Walk

One theory of stock market performance is that stock prices follow a random walk. That is, prices are affected enough by random events as to defy any predictability. For proponents of random walk theory, the randomness of stock prices is the dominant feature that drives investment strategies. Investors should focus their investments on overall market indexes since the prices of individual stocks are inherently random, preventing investors from outperforming general indexes.

Technical Analysis

Technical analysis is another approach to stock investing that takes the view that future stock performance is not random, and is largely predictable if an investor identifies the factors that the stock price has responded to in the past. Like weather forecasters, technical analysts don't expect perfect predictions. But they do make predictions on the premise that randomness doesn't overwhelm predictability. Technical analysts often work with large databases and complex computer programs designed to test factors that move a stock's price. These same factors are then tracked in real time to guide current investment strategies.

Fundamental Investing

Many investors base their investment decisions on an understanding of the fundamental performance of a company, including factors such as financial health, management experience, customer demand and the presence or absence of major lawsuits or regulatory problems. These traditional investors recognize that seemingly random events, such as an earthquake, can have an unanticipated impact on a company's performance and stock price. At the same time, random impacts are offset by factors that lend themselves to some predictability even in the absence of formal technical analysis of trends.

                   

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About the Author

David Sarokin is a well-known specialist on Internet research. A former researcher with Google Answers, he has been profiled in the "New York Times," the "Washington Post" and in numerous online publications. Based in Washington D.C., he splits his time between several research services, writing content and his work as an environmental specialist with the federal government.

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