What would you do if market prices were truly a random walk?

[Lucky C]

I think the majority of us on the forum would agree that prices in the markets (whether equities, debt, or real assets) do not follow a random walk as some academics hypothesize. My question is, if tomorrow it was proven (and you were convinced) that market prices will follow a 100% random walk* going forward, how would that change your investment philosophy/strategy and your FIRE plans?

I know some who think markets are not random at all will think this question makes no sense as it would be impossible for markets to be 100% random, but it's just a hypothetical so imagine whatever "magic" would be necessary to make it happen. Perhaps powerful AI trading systems are switched on tomorrow that dominate all trades, implementing a bunch of different uncorrelated types of trades in such a way that price movements are indistinguishable from random changes. However assume that volatility in the markets remains what it typically has been in the past, so it's not complete chaos.

Others who think the markets are nearly random, or random enough to not bother with active management, might not do anything differently in this scenario.

The point here is not to debate whether or not the markets follow a random walk, but what would you do differently if you knew they did?

*Future price movements in an asset are completely independent of past price movements.

[ertyu]

let's assume price action was indeed completely random, fully divorced from fundamentals and liquidity, and independent of trader sentiment. Furthermore, markets were not path-dependent either. In that case, you would expect future price to be normally distributed around current price. As far as I know, the random walk does not assume that market price is random, it assumes that the price "trendline" is determined by economic growth in fundamentals and that deviations around that line are "noise," and it is that noise which is random.

If you want to assume that the stock market is fully and completely random (independent of inflation also??) I would probably pull out completely and see if I can generate returns elsewhere, e.g. through real estate, lumber, or starting a business.

If the market is indeed a random walk around the economic growth trend line (i.e. what is random and iid is the "errors"), I would buy vol with part of my portfolio and wait until valuations catch up with fundamentals - which, if you believe that the real trend line is determined by real gdp growth, they will (inflation protection for the interim?). Then I would try to kinda-time the bottom, waiting for "fair" return, and I would index from that point forward.

[jacob]

Obviously it matter if there's a trend line or not. If not, it just becomes a lottery. Some would still play that.

Presuming that enough people does, I would switch entirely to bonds and options. These can be priced to extract a rent from randomness (aka selling insurance) insofar the randomness is bounded. For example, even if a market price of a bond is random, you still know you get the principal back at a set date, so all you had to decide was whether the now random interest rate was good enough before buying. (Others would do the same and thus it would be very hard to keep the price random as long as enough people held to maturity. (In reality, many now hold bonds in ETFs and have no clue about what they're holding or when it's maturing, so the ETF price is a reflection of "random" fluctuations of the market interest rate + dross.) Vanilla options are---if the price is really random---essentially a play on vol which is mean reverting, so buy low, sell high. In reality, options are more instruments of speculative leverage.

A greater point is that the market finds a way. Even though market prices are nearly random, vol is bounded/heteroskedastic and tends towards mean reversion. Insofar enough people started on this [more sophisticated] trade, intuitively, you'd find the same effect in vol-vol (the volatility of volatility <- which currently makes less sense).

[Lucky C]

@ertyu Yes I would say there has to be some dependence on economic growth over the long run. However over the short term, random price movements could still expose you to sequence of returns risk if you need to make withdrawals for living expenses, even if the economy recovers well. E.g. the S&P500 won't randomly work its way down to a price of 200 (last seen in the 1980's). However over the next year, random price movements could easily bring it down to 2000 or up to 4000 if volatility stays higher than average.

@jacob, I believe you now have over 100 years' worth of expenses? In your situation, why not stick with primarily dividend-paying stocks assuming you can live off the yield and not care about random price movements?

[Lemur]

@Lucky C

If marked prices were truly random then I would basically either buy bonds or sell options. My thinking here is that 'FIRE' uses growth projections and if I'm ever going to reach 'my number' then I can't let my money be handled by randomness....so bonds and selling options OTM options it is.

[jacob]

@LuckyC - That's pretty much what I do now (dividend payers with above average balance sheets). However, currently prices are not entirely random.

I presumed we were talking hypotheticals?

[Lucky C]

Yes hypothetical, but I was wondering if when you say you would switch to bonds and options, do you mean if you were starting out investing now or do you mean with your current account balance i.e. 1% or lower withdrawal rate?

[jacob]

I mean in general. It would be the only way to invest for a non-random return.

I am kinda struggling to see the point of this discussion though? If we're supposed to learn anything beyond alternative reality markets, I'll note that with <1-2% SWRs, investing in inflation-protected treasuries ala Bodie also becomes an option even in a ZIRP environment.

I know there are people rich enough not to even bother with inflation protection. They just keep everything in a checking account.

[Lucky C]

One point of the discussion is to think about if your investing or trading strategy is dependent on markets NOT being very random at all. A less extreme question: what if the markets are significantly more random or efficient than you think they are? After an investor/trader realizes the market is not an ideal random walk, they might overcompensate after this realization and turn to a strategy that is too reliant on the market being predictable rather than random. It seems like there are people (generally, not just this forum) who either "know you can't beat the market" and so they do passive indexing or people who know that skillful investors/traders can profit from the markets and immediately jump into the first strategy that makes sense to them thinking that if the market isn't random, any decent sounding strategy can beat it. Of those who recognize that markets aren't completely random, there aren't a lot who think "of course it's not random, but it's random enough that I don't think I can reliably profit from the little bit of non-randomness."

So I think it is beneficial to question what would happen to your strategy if the market is more random or efficient than you think it is. Would your portfolio still survive or would your strategy blow up? Or would it most likely do OK but not be performing well compared to "the market"? If you consistently lag the market year after year, when would you give up?

The second point is my selfish desire to learn something from this discussion. I'm curious to see if someone brings something up that I have been thinking about lately, without me explaining in detail. The "something" I had in mind would be contentious and I'm not looking to debate it; I'm trying to see if anyone else has had the same thought process. Sorry to be mysterious.

[shemp]

I think OP misunderstands the phrase "random walk", which was popularized by Burton Malkiel's "A Random Walk Down Main Street". The idea of "randomness" is that stock prices are based on fundamentals, but fundamental information arrives over time in a random manner, thus short-term price movements reflect this.

For example, if a mine collapses, mining company stock will ultimately reflect disaster by a lower stock price, based on discounted dividend model. But knowledge of the disaster, and calculations of the effect on long term company profits and thus company stock value, do not happen instantaneously. Rather, there are rumors of the disaster, then people have to estimate the effect of profits, then rumors are confirmed, etc. As each market participant acts on information received, price adjusts slightly. And this gives the appearance of a random walk.

Plus you have noise traders (dumb money) layered on top of the fundamental based traders, and this crowd adds more randomness.

Random walk model should be contrasted with technical analysis model, whereby prices are based more on trader psychology than company fundamentals. For example, a sharp move up is always followed by partial retracement, as traders who owned at the initial price take profits. "Back and fill action" eventually creates base for another sharp move up, because everyone who wanted to sell at the previous peak has done so, so no one left to sell. And so on. None of this technical analysis is concerned with what the company actually does. Technical analysis can just as well be used for trading Beanie Babies as stocks.

Professional traders traditionally used mostly technical analysis while professional investors traditionally used fundamentals to determine rough entry/exit points, then technical analysis to fine tune decisions. That is, if you are an investor willing to buy at 100 but charts suggest capitulation not yet reached at 100 and trend is down, then maybe wait a little and get a better price.

Efficient market theorists argue that while both fundamental based and technical based trading might have worked in the old days, when markets were thinly traded and information moved slowly, nowadays there is too much smart money quick to take advantage of even slight pricing anomalies, so that without some clear information advantage, most traders are now actually dumb money noise traders, adding to market randomness. In particular, computers have mostly replaced professional traders for short term technical based trading. Proof of this is the huge profits earned my Renaissance Technologies. This profits came from human traders who foolishly dared compete with computers at short term technical based trading. As fur investing based on fundamentals, humans still dominate there, but competition is fierce, so that very few hedge funds can compete with indexes after taking subtracting fees.

I tend to agree with efficient market theory, other than for long term tactical asset allocation. For example, there is a limited amount of smart money that can abandon the stock market entirely for cash/bonds and stay cash for 3 years, then switch to 100% stocks after 3 years. If you can do this, you can take advantage of overpriced markets like in 1999 or 2007, which are followed by crashes. Plenty of other examples of strategies that are impossible for institutional investors because of client impatience at doing something both different and unprofitable for several years on end. Lack of competition opens the possibility of better than average performance forn those who can follow unorthodox strategies.

Most important rule when trying to beat the market: first identify the dumb money you plan to win against. Explain why this dumb money is dumb compared to you, and why no one else is going after this dumb money, and why no one else is treating you like dumb money.

[Lucky C]

To clarify, by "random walk" I mean:
Future price movements in an asset are completely independent of past price movements.
I will put this in my first post to avoid confusion.

Again, this is a hypothetical of what you would do if I snapped my fingers and magically made this come true, however impossible it may be.

[shemp]

Future price movements in an asset are completely independent of past price movements.

This is what efficient market theory argues. Information arrives randomly, thus price adjusts randomly. Taking my mine disaster example again, when the first trader hears the first rumor, he sells. Then someone else hears the rumor, somore selling. Then someone who hears the rumor calculates and realizes selling was excessive, so he buys and price goes up. Another guy calculates and decides, no, selling was not excessive, so he sells and price goes down again. On and on, as thousands of market participants receive better and better information and make better and better calculations. Constant tiny price changes, all based on fundamentals, but impossible to predict these price changes because each change is the result of partial information, different personalities receiving the information at different times and making different calculations.

Technical analysis says that at least some price changes (and also price anomalies) are predictable, because some changes/anomalies are based on human psychological factors which are predictable and constant over time. All sharp moves up are followed by a partial retracement down, because of underlying psychological factors, was the example I gave above.

I agree with the technical analysis view in theory, but in practice I think the days when humans could take advantage of short term technical analysis are over. Computers run by big hedge funds (Renaissance Technologies) do this much better.

Long term technical analysis is still viable, if used with fundamental analysis: I believe long term price bubbles do occur and they are easy to spot, though not so easy to take advantage of them. Severe underpricing is less common and typically doesn't last long, since there is usually enough smart money in cash to snap up bargains as they occur. For example, when oil futures dropped below zero recently, smart money in the oil and shipping industies quickly figured out ways to boost storage capacity to take advantage of this exceptional bargain.

[Nomad]

Similar to what I do now. I have funds in various markets and asset classes. I would rebalance once a month. Sell what went up to buy what dropped on value. This would work assuming the random.price is somewhere around a particular value.

[Bankai]

I agree with the technical analysis view in theory, but in practice I think the days when humans could take advantage of short term technical analysis are over. Computers run by big hedge funds (Renaissance Technologies) do this much better.

I don't suspect many hedge funds achieved returns anywhere close to these in 2020. Perhaps liquidity matters...

[shemp]

@Bankai: I don't know the details of that contest, but plenty of lottery winners do much better: +100,000,000% in a single week in some cases (buy one $1 ticket, win $1,000,000). Better hedge funds, like Renaissance, are consistent winners over decades. Are those investment contest winners also consisten winners?

[Lucky C]

A couple of the interviewees in the original Market Wizards book were winners in these investing championships. One of them won 9 out of the 10 that he participated in, and of course since he is featured in Market Wizards, he consistently beat the market over his career as either a money manager for others or just trading his own account (I forget which in his case).

Of course some of these legendary traders ending up crashing and burning after decades of success since they trade futures and such with huge amounts of leverage. Investing championships are over such short periods of time that yes you are bound to get some who make several hundreds of percentage points, but others may go to zero in just a few months. Legendary traders a la Market Wizards can consistently get 20%-100% over several years with the occasional losing year and a non-trivial chance to go to zero at some point in one or two decades. Compared to traditional fund managers who will usually be within a few percentage points of their benchmark, never beating the market by 20%+ annually, but never going to zero either.

[shemp]

@LuckyC: Market Wizards was written long ago. As I wrote previously, what appear to random market fluctuations are probably not entirely random because of underlying human psychological biases. The underlying patterns are what Market Wizards guys were taking advantage of. Then along came Renaissance Technologies in the 1990's, using computer pattern matching to do what traders did by hand previously, but do it infinitely faster and more accurately. I doubt humans can compete in short-term trading anymore. Long-term another story, especially 3+ years which is where clients abandon funds that underperform. In any case, hedge funds ARE the market wizards of today.

[Bankai]

The average hedge fund returned 11.6% in 2020, according to Hedge Fund Research data, lagging behind the S&P 500 index’ 16% gain.

https://www.reuters.com/article/us-hedg ... SKBN29U00R

Quant pioneer Renaissance Technologies LLC sent clients an analysis of its performance and a rationalization of recent deep losses, an unusual move for one of Wall Street’s most secretive firms.

In the letter sent late Friday, the firm said losses of between 20% and 30% in 2020 for its three funds open to outside investors should have been expected at some point during the course of the funds’ histories. The letter partly blamed heightened volatility for the weak performance.

https://www.wsj.com/articles/renaissanc ... 1611008784

[nomadscientist]

But what is the P/E of a hedge fund's holdings?

[shemp]

@Bankai: Renaissance Technologies has a special fund that is NOT open to outsiders. That's the one which has dominated short-term trading for past 30 years. I have no idea what the open funds are about. They may not be similar to that closed fund. Also, every dog has its day. It's quite possible another group is now beating RT at their own game, using better computer algorithms.

Also, comparing "average" hedge fund to either SP500 mch less winners of some investing contest is apples to oranges. What is interesting is top hedge funds (or other professionals) over long periods compared vs SP500 or amateurs. We know that most money managers underperform, and no one to know who the underperformers are in advance, which is precisely why most smart people either use an index fund or do their own stock picking.

You could argue that the real skill of professional money managers (only some of whom operate as hedge funds, other as mutual funds, others as traders for banks or endowments) is to convince people to trust them rather than to actually manage money well. That is definitely true for clowns like John Hussman Ph.D., who panders to frightened old people with his constant talk of impending doom, but not all of them. Warren Buffett, for example, has shown unquestionable skill. If you are going to argue Buffett is incompetent based on last decade vs SP500, then you're just a fool not worth arguing with.

Getting back to the OP, which was poorly phrased. Read the Wikipedia article to understand the term better, though even that article confuses things. Random walk theory says technical analysis is bunk, not that fundamental analysis is bunk, because denying prices have anything to with fundamentals is just stupid. That is, Random Walk Theory says you can't predict the future price just looking at a graph of past prices. Jim Simon of Renaissance Technologies put their money betting against the Random Walk Theory about 30 years ago, and became a multi-billionaire as a result..The Market Wizard turtles did something similar prior to RT. Jesse Livermore (Reminiscences of a Stock Operator) was another famous technical analyst of the early decades of the 20th century. All these tech analysts worked all of stocks, commodities, bonds, foreign exchange. Anything with lots of volatility. They payed no attention to underlying fundamentals, but rather looked just at price trends. Their success indicates that Random Walk Theory is false.

As I noted previously, and as the Wikipedia article suggests, success of technical analysis is probably because of consistent human psychological biases. The real question is whether humans are better at detecting and exploiting such biases versus pattern matching computers. Renaissance Technologies bet on computers and I think they are correct here. Basically impossible for humans to beat computers at things computers much better, and pattern matching/detection using billions of pieces of data is one such domain where computers excel. Maybe Renaissance Technologies is no longer the consistent winner they were over past 30 years. But of not them, then I'm certain the new winner is another high-speed computer trading system, and not some guy sitting at home using pen and paper to compete with computers. (To reiterate. we are talking technical analysis here. For fundamental analysis, pen and paper combined with human insight might still outperform.)