15.

481x Financial Market Dynamics

and Human Behavior
Andrew W. Lo, MIT
Lecture 2: Rejecting the Random Walk
and Efficient Markets

Lecture: The Random Walk Hypothesis

The Conundrum
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An Observation
Many Disciplines Focus On Human Behavior
§ Anthropology
§ Biology
§ Computer Science
§ Economics
§ Neuroscience
§ Organizational Science
§ Political Science
§ Psychology
§ Sociology
What Is The Common Denominator? Homo sapiens
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 15.481
An Observation
Consilience (E.O. Wilson, 1998):
The Consilience of Induc/ons takes place when an Induc/on,
obtained from one class of facts, coincides with an Induc/on,
obtained from another different class. This Consilience is a test
of the truth of the Theory in which it occurs.
— William Whewell, 1840, Philosophy of
the Induc1ve Sciences, 1840.

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 15.481
An Observation
Consilience (E.O. Wilson, 1998, p. 182):
There is also progress in the social sciences, but it is much slower, and not at all animated
by the same information flow and optimistic spirit…
The crucial difference between the two domains is consilience: The medical sciences have
it and the social sciences do not. Medical scientists build upon a coherent foundation
of molecular and cell biology. They pursue elements of health and illness all the way
down to the level of biophysical chemistry…
Social scientists by and large spurn the idea of the hierarchical ordering of knowledge that
unites and drives the natural sciences. Split into independent cadres, they stress
precision in words within their specialty but seldom speak the same technical
language from one specialty to the next.

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 15.481
The Challenge
Can We Construct a Complete
Theory of Human Behavior?

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 15.481
The Challenge
§ Rationality is not supported by the data
§ Cognitive and behavioral biases
– Loss aversion, anchoring, framing
– Overconfidence
– Overreaction
– Herding
– Mental accounting
Then It Should Be Easy To Make Money, Right??
© 2020 by Andrew W. Lo
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Origins of the
Random Walk
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A Brief History of the Random Walk
Earliest Model of Asset Prices:
§ Notion of “fair” game
§ The martingale
§ Cardano’s (c.1565) Liber De Ludo Aleae:
The most fundamental principle of all in gambling is simply equal conditions, e.g.
of opponents, of bystanders, of money, of situation, of the dice box, and of the
die itself. To the extent to which you depart from that equality, if it is in your
opponent's favor, you are a fool, and if in your own, you are unjust.
§ Precursor of the Random Walk Hypothesis

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 15.481
A Brief History of the Random Walk
Louis Bachelier (1870–1946) and Brownian Motion
§ Ph.D. (math) advisor: Henri Poincaré
§ Thesis (1900) involved pricing warrants on the Paris Bourse
§ Developed mathematics of continuous-time random walks
§ Past returns cannot be used to forecast future returns
§ Poincaré’s evaluation of Bachelier:
The manner in which the candidate obtains the law of Gauss is most original, and all the
more interes6ng as the same reasoning might, with a few changes, be extended to the
theory of errors. He develops this in a chapter which might at first seem strange, for he
6tles it “Radia6on of Probability”. In effect, the author resorts to a comparison with the
analy6cal theory of the propaga6on of heat. A liEle reflec6on shows that the analogy is
real and the comparison legi6mate. Fourier's reasoning is applicable almost without
change to this problem, which is so different from that for which it had been created. It is
regreEable that [the author] did not develop this part of his thesis further.
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 15.481
A Brief History of the Random Walk
Robert Brown (1773–1858)
§ Discovered “Brownian motion” in 1827
§ Movement of pollen grains suspended in fluid

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 15.481
A Brief History of the Random Walk “On the Motion of Small Particles
Albert Einstein (1879–1955) Suspended in a Stationary Liquid, as
Required by the Molecular Kinetic

§ Annus Mirabilis (1905) papers: Theory of Heat”

– Photoelectric effect
– Brownian mo/on
– Special rela/vity
– E = mc2

M. Fowler, UVa (2008)

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 15.481
A Brief History of the Random Walk
The Random Walk Hypothesis:

§ If Xt represents price, arithme/c random walk

§ if Xt represents log-price (log Pt), geometric random walk
(sa/sfies limited liability)
§ Suppose et is normally distributed:

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 15.481
A Brief History of the Random Walk
The Random Walk Hypothesis:
§ Increments Xt - Xt-1 are uncorrelated (white noise)
§ Samuelson (1965), “Proof that properly anticipated prices
fluctuate randomly”
§ Financial argument for randomness—greed!
§ Related to, but not the same as, Fama (1970): “prices fully
reflect all available information”
– Implies that technical analysis, fundamental analysis, and
active management are a waste of time!
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 15.481
A Brief History of the Random Walk
This cannot persist: This can persist:
$ 80 $ 80

70 75

60 70

50 65

40 60

30 55

50
20
0 10 20 30 40 50 60 70 80 90 100

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 15.481
A Brief History of the Random Walk

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Classical Tests of the
Random Walk
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The Sociology of Academic Finance
Early Tests of the Random Walk
§ Sequences/Reversals, Runs
– Cowles and Jones (1937), Cowles (1960), Fama (1965), Moore (1962)
§ Filter Rules:
– Alexander (1961, 1964), Fama (1965), Fama and Blume (1966)
§ Spectral Analysis:
– Granger and Morganstern (1963)
§ Serial Correlation:
– Kendall (1953), Larson (1960), Moore (1962)
§ Long-Range Dependence and R/S Analysis:
– Granger (1966), Green and Fielitz (1977), Mandelbrot (1971, 1972), Steiger (1963)
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 15.481
The Sociology of Academic Finance
Early Tests of the Random Walk
§ Other Tests and Related Papers:
– Cootner (1962), Mandelbrot (1963), Niederhoffer and Osborne (1966), Osborne (1959, 1962), Roberts
(1959), Working (1960)
§ Conclusion Þ random walk not rejected
§ However, some rejections were reported (and ignored)
§ Random walk was tied to efficient markets
§ Theory implied that markets must be efficient
§ What happens when data contradicts the theory??
§ Niederhoffer’s (1997) experiences as a UChicago finance Ph.D. student
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 15.481
The Sociology of Academic Finance
Early Tests of the Random Walk
Victor Niederhoffer:
§ Squash champion
§ National Champion 1966, 1972, 1973, 1974, 1975
§ National Doubles Champion 1968, 1973, 1974
§ North American Open 1975
§ UChicago Ph.D. (1969), UC Berkeley professor (1967–1972)
§ Niederhoffer Investments compound annual return of 35%
(1980–1996)
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 15.481
The Sociology of Academic Finance
Niederhoffer (1997):
This theory and the attitude of its adherents found classic expression in one incident I personally observed
that deserves memorialization. A team of four of the most respected graduate students in finance had
joined forces with two professors, now considered venerable enough to have won or to have been
considered for a Nobel prize, but at that time feisty as Hades and insecure as a kid on his first date. This elite
group was studying the possible impact of volume on stock price movements, a subject I had researched. As
I was coming down the steps from the library on the third floor of Haskell Hall, the main business building, I
could see this Group of Six gathered together on a stairway landing, examining some computer output. Their
voices wafted up to me, echoing off the stone walls of the building. One of the students was pointing to
some output while querying the professors, “Well, what if we really do find something? We'll be up the
creek. It won't be consistent with the random walk model.” The younger professor replied, “Don't worry,
we'll cross that bridge in the unlikely event we come to it.”
I could hardly believe my ears—here were six scientists openly hoping to find no departures from ignorance.
I couldn't hold my tongue, and blurted out, “I sure am glad you are all keeping an open mind about your
research.” I could hardly refrain from grinning as I walked past them. I heard muttered imprecations in
response.
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Technical Analysis
 15.481
Using Geometric Patterns for Forecasting

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 15.481
Cultural Differences

On The Fundamentals Of Technical Analysis

Andrew Lo

© 2020 by Andrew W. Lo
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 15.481
Cultural Differences
Compare:
The presence of clearly identified support and resistance levels, coupled
with a one-third retracement parameter when prices lie between them,
suggest the presence of strong buying and selling opportunities in the
near-term.
With:
The magnitudes and decay pattern of the first twelve autocorrelations
and the statistical significance of the Box-Pierce Q-statistic suggest the
presence of a high-frequency predictable component in stock returns.

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 15.481
Cultural Differences
Both Statements Refer to the Same Phenomenon
§ Short-term predictability, and possible trading opportunity
§ But there are differences:
– Clear and generally accepted definitions
– Rigorous and testable hypotheses and implications
– Proper statistical inference
– The spirit, language, and process of scientific inquiry

© 2020 by Andrew W. Lo
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 15.481
Academic PerspecFves
Theoretical Underpinnings:
§ Treynor and Ferguson (1985)
§ Brown and Jennings (1989)
§ Grundy and McNichols (1989)
§ Easley and O'Hara (1994)
§ Clyde and Osler (1997)

Þ Technical Analysis Can Work

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 15.481
Academic Perspectives
Empirical Evidence:
§ Lo and MacKinlay (1988, 1990)
§ Pruitt and White (1988)
§ Brock, Lakonishok, and LeBaron (1992)
§ Allen and Karjalainen (1993)
§ Chang and Osler (1994)
§ Ready (1997)
§ Lo, Mamaysky, and Wang (2000)

Þ Technical Analysis Does Work

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 15.481
Academic Perspectives
What Does It Mean To “Work”?
§ Profitability
§ But what about risk?
§ Requires an “equilibrium model”

Less Ambitious Goal:

§ Are technical patterns informative?
§ Do they change the conditional distribution of returns
§ Compare unconditional and conditional distributions
§ Condition on various technical patterns

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 15.481
Academic PerspecFves
More Formally, Compare:

§ Apply Kolmogorov-Smirnov “goodness-of-fit” test

§ “Distance” between two distribution functions
§ Lo, Mamaysky, and Wang (2000):
– Develop algorithm for identifying patterns
– Find patterns in historical data
– Compute post-pattern return distributions
– Compare with unconditional return distribution

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 15.481
Academic Perspectives

Identification Process:
1. Fit kernel regression in window
2. Identify extrema E1,…,En of fitted
curve
3. Use extrema to identify patterns
4. Move window forward and go to
step 1
Example: Head-and-Shoulders (HS)

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 15.481
Academic Perspectives

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 15.481
Academic PerspecFves
What Did We Find?
§ Studied 10 patterns
Head-and-Shoulders Inverse Head-and-Shoulder
Broadening Top Broadening Bottom
Triangle Top Triangle Bottom
Rectangle Top Rectangle Bottom
Double Top Double Bottom
§ 100 individual stocks from 1962 to 1996, 5-year sub-periods
§ Random sampling from market-cap quintiles
§ Studied distributions of normalized daily returns
§ Also simulated random walks for each stock
© 2020 by Andrew W. Lo
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 15.481
Academic Perspectives
What Did We Find?
§ For NYSE/AMEX stocks, mixed results
§ For NASDAQ stocks, strong significance across all patterns
§ Simulations cannot explain these results
§ Difficult to attribute to “statistical fluke”

Technical Patterns Are Heuristics!

§ Where do they come from?
§ How long do they last?
§ When do they break down?
§ How do new heuristics come about?
§ What can we say about the “science” of technical analysis?
© 2020 by Andrew W. Lo
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 15.481
Practitioner Perspectives
Interviews with Leading Technicians
§ Ralph Acampora
§ Laszlo Birinyi
§ Walter Deemer
Thanks to Mike Epstein!
§ Paul Desmond
§ Gail Dudack
§ Robert Farrell
§ Ian McAvity
§ John Murphy
§ Robert Prechter
§ Linda Raschke
§ Alan Shaw
§ Anthony Tabell
§ Stan Weinstein

© 2020 by Andrew W. Lo
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