Random walk theory and financial markets
Random walk theory comes from the concept of Brownian motion. The first to raise the question that the random movement of particles is similar to fluctuations in financial markets was the French researcher Louis Bachelier at the beginning of the 20th century.. His ideas were later developed by the American economist Burton Malkiel.
The concept of a random walk emphasizes the complexity of the task of constantly “outplaying” the market based on the correct choice of instruments and timely execution of transactions, since the prices of the current period do not depend on what happened in the past.
By and large, the ideas of Bachelier and Malkiel call into question the effectiveness of technical analysis. Market efficiency will destroy all opportunities for above-average profits. This postulate is the cornerstone of the application of random walk theory in economics. Market efficiency in this case means that the current price of an asset represents complete information.
The idea has both supporters and opponents. Essentially, random walk theory clearly hints at the need for diversification and passive strategies for investors, such as investing in index funds.. The basis of this theory includes two hypotheses.
Market efficiency hypothesis
This hypothesis has three interpretations:
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Weak: historical data cannot be used to make a profit in the market, since past prices and volumes are already included in the current price of a particular instrument;
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Average: prices include all publicly available information (past and current), thus negating the need for fundamental analysis and insider information;
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Strong: all knowledge and data, including insider information, are already taken into account in market prices; any analysis seems useless for permanent earnings in the market.
Random walk hypothesis
By random walk we mean the independence of price changes from each other, like a “walking” object. The fundamental premise is the fact that future prices are completely random and they are in no way related to past movements at any point in time. Thus, the postulates of this hypothesis call into question the significance of the analysis of future prices, which is based on past events.
Random walk theory and cryptocurrency markets
From the perspective of random walk theory, the crypto market is no different from any other. Prices for crypto assets are arbitrary. Technical and fundamental analysis are practically useless, since the value of cryptocurrencies depends on a wide range of uncontrollable factors.
Evaluating Trading Strategies
Random walk theory rejects the effectiveness of short-term trading. In addition, its main provisions imply the uselessness of technical analysis based on data from the past.. Short-term traders typically face problems assessing factors over a short period of time.
Risk management
Assuming a random walk in cryptocurrencies, their prices are somewhat unpredictable. Therefore, investors should base their investment strategies on diversification to avoid unnecessary risks.
Market efficiency analysis
According to random walk theory, all available information is quickly reflected in prices. Analysis of market efficiency will depend on the speed with which data is taken into account.
Investor training
Random walk theory shows the shortcomings of forecasts that are made based on the analysis of events from the past. It highlights new aspects that should be taken into account before making investment decisions.
Long-term investing
To most effectively cope with the challenges that such a complex instrument as cryptocurrency poses to investors, it is worth giving preference to long-term investing and portfolio diversification. This is completely consistent with the postulates of the random walk theory.
Bitcoin and random walk theory
There is no consensus on whether the price of Bitcoin changes randomly. There are arguments both for and against.
Arguments for”
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If we assume that the market is as efficient as possible, that is, it uses all opportunities at once, and prices include all comprehensive information, then Bitcoin fully complies with the random walk theory.
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BTC trading is a constant phenomenon over time, so all events and news can quickly affect its price. The result of this will be volatility, which is completely consistent with the theory of random walk.
Arguments against”
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Cryptocurrency prices at a given point in time do not reflect absolutely all the opportunities available to traders and investors.
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Behavioral and external factors. Speculation, Psychology and Market Sentiment Determine How Bitcoin Moves. These components are at odds with random walk theory. Unlike conventional financial markets, macroeconomic events, technological innovations and regulatory changes have a direct impact on the price of BTC. Thus, the strict postulates of random walk theory are not always applicable here.
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Advocates of technical analysis, with the help of certain tools, can make progress in extracting profits from the markets. Thus, they prove that prices can be predictable, including in the short term, which does not directly correspond to the random walk theory.
Disadvantages of random walk theory
The main drawback of the random walk theory for cryptocurrencies is the main postulate that all information is already taken into account in prices. Price movements are extremely volatile and speculative in nature. They are influenced not only by fundamental factors. In addition, the theory absolutely denies the presence of trends and patterns inherent in technical analysis.
The potential impact of external events such as security breaches, regulatory changes and technical discoveries, which could have a significant impact on cryptocurrency price movements, is another drawback.. Certain market indicators may be ignored due to denial of repeating patterns.
In addition, the random walk theory does not take into account situations where the price deviates from the fundamental value. Examples include bubbles and individual manipulative strategies – cryptocurrency markets are relatively young and susceptible to the influence of the latter.
Conclusion
The random walk theory emphasizes the weaknesses of the technical analysis of cryptocurrency markets, but does not take into account possible volatility and the presence of patterns in trending price movements. From a practical perspective, this concept speaks to how important diversification is when constructing an investment portfolio.
This material and the information contained herein do not constitute individual or other investment advice. The opinion of the editors may not coincide with the opinions of the author, analytical portals and experts.