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The random-walk theory of stock prices is the best-tested and

best-verified theory in economics!

Many statistical tests support the random-walk theory.

Financial Economics

Most theories in economics are difficult to test with data.

The key problem is that typically a controlled experiment is not

possible. The economist makes inferences from observed data.

(Astronomy shares this trait with economics.)

Financial Economics

Ceteris Paribus

Economic theory postulates a relationship between two

economic variables, with other things held constant. Yet in

practice many things change simultaneously, and the alleged

relationship cannot be isolated.

Financial Economics

Downward-Sloping Demand?

A simple example is the theory of demand. Although all

economists believe that the demand curve for a good is

downward-sloping, to establish this relationship by data is

extremely difficult.

Financial Economics

Success

Perhaps the success of the statistical testing of the

random-walk theory is that the theory applies regardless of

whether other things change.

Financial Economics

Surprising Result

This success has surprised many people, as many have believed

that skillful use of technical analysis (charting) allows one to

make economic profits.

Financial Economics

Statistical Testing

The random-walk theory asserts that there is no pattern to

stock-price changes. In particular, past stock-price changes do

not enable one to predict future price changes.

One tests the theory by investigating whether any forecasting is

possible. Do past stock-price changes enable one to forecast

future price changes? Even a small ability to forecast would

contradict the random-walk theory.

Financial Economics

A simple non-statistical test is just to graph a stock price as a

function of time. The jagged appearance of the graph conforms

with the random-walk theory. As the price change at one

moment is uncorrelated with past price changes, the incessant

up-and-down movement makes the graph jagged.

If the graph were smooth, this finding would contradict the

random-walk theory. A movement up or down would continue,

perhaps only for a brief time, but this continuation would create

an opportunity for economic profit.

8

Financial Economics

Correlation

A simple statistical test of the random walk theory is to

calculate the correlation of the stock-price change during a

period with the stock-price change during a previous period.

For example, one can calculate the correlation of the daily

stock-price change with the change on the previous day, or with

the change two days ago.

The random-walk theory says that this correlation must be

zero. Any non-zero correlation would allow one to forecast the

future stock-price change somewhat, and one could make an

economic profit.

9

Financial Economics

Sample Correlation

One tests the theory by calculating the sample correlation for

stock-price changes.

A statistical test allows for possible random variation in the

data. If the sample correlation is far from zero, one infers that

the random-walk theory is probably wrong, as this value is

unlikely to occur by chance. If the sample correlation is near

zero, then the data are consistent with the theory.

10

Financial Economics

Probability Distribution

of the Sample Correlation

If the true correlation is zero, the probability distribution of the

sample correlation is approximately normal, with mean zero.

The standard deviation of the sample correlation is

1

,

n

in which n is the number of observations.

11

Financial Economics

Critical Value

The critical value refers to the borderline value for accepting or

rejecting the null hypothesis that the random-walk theory is

true.

If the random-walk theory is valid, then 95% of the time the

sample correlation will lie within 1.96 standard deviations of

zero.

12

Financial Economics

1.96

.

n

One rejects the random walk if the sample correlation lies away

from zero by more than this critical value. An increase in the

number of observations reduces the critical value.

13

Financial Economics

Example

For n = 400, then

1.96 1.96

=

= .098.

n

20

14

Financial Economics

Accept

If the sample correlation is no further than .098 from zero, then

one accepts the null hypothesis that the random-walk theory is

valid, as any value this near zero is compatible with the theory.

15

Financial Economics

Reject

If the sample correlation is further than .098 from zero, then

one rejects the null hypothesis that the random-walk theory is

valid. If the random-walk theory were valid, then a value this

far from zero could happen only with probability 5%, so the

data suggests that the theory is wrong.

16

Financial Economics

Runs Test

Another simple statistical test is a runs test. For daily data, a

run is defined as a sequence of days in which the stock price

changes in the same direction.

For example, consider the following combination of upward

and downward price changes:

++++++.

A + sign means that the stock price increased, and a sign

means that the stock price decreased. Thus the example has

7 runs, in 12 observations.

17

Financial Economics

Momentum

Momentum investing rejects the random-walk theory. The

assumption is that trends continue: a price increase implies

further price increases; a price decrease implies further price

decreases. One buys when the stock price is rising and sells

when it is falling.

18

Financial Economics

For n observations, what is the expected number of runs?

19

Financial Economics

runs is

n

.

2

Each day the probability that a new run starts is one half, and

the probability that the current run continues is one half.

20

Financial Economics

Hence the expected number of runs is less.

21

Financial Economics

One-Tailed Test

One tests the theory by calculating the number of runs in a data

set. A one-tailed test is natural, as the momentum theory

predicts fewer runs than the random-walk theory.

If the random-walk theory is true, the expected number of runs

is n/2, and the standard deviation of the number of runs is

n

.

2

With probability 5%, the number of runs will lie more than

1.64 standard deviations below the expected value, and this

number is the critical value.

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Financial Economics

Example

For n = 400, then

n

= 16.4.

1.64

2

The expected number of runs is 200.

Hence one rejects the null hypothesis that the random-walk

theory is true if the number of runs is 183 or less; this low

number could occur by chance only 5% of the time.

If the number of runs is 184 or more, than one accepts the null

hypothesis. This number is close enough to 200 to be

compatible with the random-walk theory.

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Financial Economics

Technical Note

A possibility is that on certain days the stock price does not

change. One can deal with this possibility just by ignoring the

observations on these days.

24

Financial Economics

Trading Rule

An implication of the efficient market/random-walk theory is

that no trading rule will yield an economic profit.

Yet some authorities have proposed a mechanical trading rule.

One can test the random-walk theory by trying out the trading

rule on historical data.

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Financial Economics

If the random-walk theory holds, the probability distribution of

the profit from a trading rule will be random.

One can carry out a statistical test by a computer simulation.

Using a random-number generator, generate n random

numbers. Using these numbers, create a random series of stock

prices. Apply the trading rule to this artificial data, and

calculate the profit.

Repeat this generation many times, to obtain a probability

distribution for the profit, valid if the random-walk theory

holds.

26

Financial Economics

One then compares the profit from the trading rule to the upper

5% tail of this probability distribution. If the profit lies in this

tail, then one rejects the null hypothesis that the random-walk

theory is valid, as there is only a 5% chance that the profit

would be so high. If the profit does not lie in the upper tail,

then one accepts the null hypothesis that the random-walk

theory is valid.

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