This is an excerpt from the Liberated Stock Trader Masterclass Training Course.
As you begin talking to friends, families, work colleagues, or even people in the financial industry, you may hear certain terms are thrown around, such as random walk theory and the efficient market hypotheses. So you need to understand what they mean and where they fit in.
Video: Efficient Market Hypothesis vs. Random Walk Theory vs. Stock Market Reality
What is Random Walk Theory in Stocks?
Economists generally argue that stock price movement is essentially random and that when you trade stocks, you are simply gambling. They state that the history of price has no bearing on the future stock price. However, we know randomness does exist but only in the short term (minutes to days time-frame).
The technical analyst sees clearly that stock prices move in trends, and we will discuss this in detail in market cycles and Fibonacci waves later. Price trends are as clear as day and night. The job of a business is to add value and create profit; this means the default direction of the market is up. However, this is interspersed with times of sideways and negative price growth. A random walk, it is not.
If we look at the random walk theory, the core principle is that stock price movement is serially independent, so they assert that the stock price is random; it essentially moves around with no basis and no relation to its historical price.
As we will see in future lessons when we study charts in detail, history does actually affect the stock price, and you will see with support and resistance trend lines. The interaction of stock price in market cycles is very much an actual factor of the way the market works.
What is the Efficient Market Hypothesis (EMH)?
Efficient market protagonists suggest that stock prices are not random and that they fluctuate around the intrinsic value of a stock, meaning that the market is efficient and always correct. Buying and holding the wrong stock can make you poor if your timing is wrong.
The more you get drawn into an academic debate about economics, the less time you can devote to investing in the stock market.
Technical analysis can be applied to all markets, foreign exchange, futures, commodities, and stocks.
In terms of the efficient market hypotheses, it asserts that prices fluctuate randomly around an intrinsic value. However, when we see the boom and bust scenarios in 2008/2009, in 2000, 1987, and the early 1970s, we see in these boom and bust situations that they don’t fluctuate randomly around an intrinsic value.
Essentially, there are so many factors in the stock market that can’t be accounted for in modern economic theory. So although economic theory is all well and good, we see that it holds a minimal bearing in the actual market itself.
We will be studying what actually happens in the stock market and how to make money out of those various actions and forces that exert themselves in the market.
The efficient market hypothesis also recommends a buy-and-hold strategy as opposed to try and beat the market.
If you want to have a very hands-off approach to investing, it may well be worth purchasing Index Tracking ETFs.
At the bottom of a bear market would be the ideal price and time to get in and buy and hold. However, as we know, the S&P 500 since the early 1970s has produced around about a six to seven percent return on investment year on year. Six or seven percent isn’t going to make you a millionaire until you retire, depending on your age, but we’re talking 30 to 50 years before that happens.
That’s really not an ideal situation to be in, so this investing training course will be all about beating the market.
Efficient Markets vs. Random Walk
|Random Walk Theory||Efficient Market Hypothesis|
|Stock Price Movement is “serially independent.”||Prices fluctuate randomly around intrinsic value.|
|Price history is not a reliable indicator of future price direction.||Recommends buy and hold as opposed to beat the market.|
The Reality of Stock Market Investing
The thing is, the more you get drawn into an academic debate about economics, the less time you can devote to making money in the marketplace.
Technical analysis of charts can be applied to all markets, foreign exchange futures commodities, and stocks. This training course will focus on fundamentals and technicals in stock prices and the stock market using potent tools such as options shorting and buying long, simply buying stocks.
It would be best if you did not polarize yourself in the fundamental camp or the technical camp; in reality, it’s a combination of both.
In terms of fundamental analysis, great companies have great fundamentals; great fundamentals, in general, mean higher company valuations, and also the higher the company value, the higher the stock price; that’s basic business.
However, on the technical side, great fundamentals do not always mean large moves in stock price; there are too many external factors that can influence the stock price.
We want to use supply and demand integrated with fundamental analysis. We’ll use technical analysis, which helps to analyze the supply and demand through price and stock price volume and sentiment psychological side of the market.
I hope this has given you a good overview of the different approaches to the stock market and sets the tone for what we will learn in future classes.
The Liberated Stock Trader Pro Training has sections on:
- Fundamental analysis, both looking at the overall context and friendliness of the economic environment to business.
- How to value a company
- How to find great companies
If you’re going to choose two stocks to buy, one company’s losing money, but the stock chart looks great, and another company is making a lot of money and expanding rapidly, and the stock chart looks great; which one are you going to choose?
That’s why you need to understand fundamental analysis.
However, we’re also going to use and focus on technical analysis. We need to understand supply and demand, how that affects stocks, and how that will affect the market.
Also, what is a great-looking stock, what indicators really make a difference, and how can you use them to make money in stocks?
The best approach to the market is to combine the very best of the Fundamental approach with the very best of the Technical approach to have a complete strategy. This means to find the very best companies with great fundamentals, like low debt, great revenue growth, and great profit growth in growing markets. Then time the investment when the market is at the right point using technical analysis. This means when the market is moving in the right direction and when the stock’s price moves in the right direction.
“The trend is your friend,” as the old proverb goes.