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The Random Walk Theory , developed and nurtured in the academic community, claims that price changes are“serially independent”and that price history is not a reliable indicator of future price direction. In a nutshell, price movement is random and unpredictable. The theory is based on the efficient market hypothesis , which holds that prices fluctuate randomly about their intrinsic value. It also holds that the best market strategy to follow would be a simple“buy and hold”strategy as opposed to any attempt to“beat the market.”
While there seems little doubt that a certain amount of randomness or“noise”does exist in all markets, it's just unrealistic to believe that all price movement is random. This may be one of those areas where empirical observation and practical experience prove more useful than sophisticated statistical techniques, which seem capable of proving anything the user has in mind or incapable of disproving anything. It might be useful to keep in mind that randomness can only be defined in the negative sense of an inability to uncover systematic patterns in price action. The fact that many academics have not been able to discover the presence of these patterns does not prove that they do not exist.
The academic debate as to whether markets trend is of little interest to the average market analyst or trader who is forced to deal in the real world where market trends are clearly visible. If the reader has any doubts on this point, a casual glance through any chart book (randomly selected) will demonstrate the presence of trends in a very graphic way. How do the“random walkers”explain the persistence of these trends if prices are serially independent, meaning that what happened yesterday, or last week, has no bearing on what may happen today or tomorrow? How do they explain the profitable“real life”track records of many trend-following systems?
How, for example, would a buy and hold strategy fare in the commodity futures markets where timing is so crucial? Would those long positions be held during bear markets? How would traders even know the difference between bull and bear markets if prices are unpredictable and don't trend? In fact, how could a bear market even exist in the first place because that would imply a trend? (See Figure 1.3 .)
Figure 1.3 A“random walker”would have a tough time convincing a holder of gold bullion that there's no real trend on this chart.
It seems doubtful that statistical evidence will ever totally prove or disprove the Random Walk Theory. However, the idea that markets are random is totally rejected by the technical community. If the markets were truly random, no forecasting technique would work. Far from disproving the validity of the technical approach, the efficient market hypothesis is very close to the technical premise that markets discount everything. The academics, however, feel that because markets quickly discount all information, there's no way to take advantage of that information. The basis of technical forecasting, already touched upon, is that important market information is discounted in the market price long before it becomes known. Without meaning to, the academics have very eloquently stated the need for closely monitoring price action and the futility of trying to profit from fundamental information, at least over the short term.
Finally, it seems only fair to observe that any process appears random and unpredictable to those who do not understand the rules under which that process operates. An electrocardiogram printout, for example, might appear like a lot of random noise to a layperson. But to a trained medical person, all those little blips make a lot of sense and are certainly not random. The working of the markets may appear random to those who have not taken the time to study the rules of market behavior. The illusion of randomness gradually disappears as the skill in chart reading improves. Hopefully, that is exactly what will happen as the reader progresses through the various sections of this book.
There may even be hope for the academic world. A number of leading American universities have begun to explore Behavioral Finance which maintains that human psychology and securities pricing are intertwined. That, of course, is the primary basis of technical analysis.