Bridge over ocean
1 July 1979 Financial Analysts Journal Volume 35, Issue 4

A Simple Counter Example to the Random Walk Theory

  1. Edward M. Miller

That New York Stock Exchange prices should follow a random walk has now become dogma in academic finance. The standard argument is simple: Any non-random fluctuations in price (other than a steady upward drift approximating the risk-adjusted rate of return) would be exploited by speculators, who would buy before an expected rise in price or sell short before an expected fall, eliminating any predictable fluctuations and making all price changes random.

This argument assumes, however, that speculators are able to sell short as readily as they can buy long. Under NYSE rules, the lender of the stock retains the proceeds of a short sale and pays no interest on them. The speculator can show a profit from a short sale only if the stock’s total return (dividends plus appreciation) is less than zero.

Thus a structural characteristic of the equities market — namely, the fact that short sellers do not receive prompt use of the proceeds of the sale — prevents rational speculators from acting to rationalize stock prices in cases where expected return is more than zero but less than the rate of return from comparably risky securities.

Read the Complete Article in Financial Analysts Journal Financial Analysts Journal CFA Institute Member Content

We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.