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Random Walks Down Wall Street


In the 1960s, Eugene Fama developed a new theory about the market called the Efficient Market Hypothesis. Fama determined that, at any given time, the prices of all securities fully reflect all available information about those securities.

While that doesn't sound so radical, most people who buy and sell stocks do so with the assumption that the stocks they are buying are undervalued and therefore worth more than the purchase price. When you haggle with a car dealer over the price of a new car, you're aiming for a price that's less than retail. When you buy a stock, you're also hoping that other investors have overlooked that stock for some reason, in effect giving you the opportunity to buy for "less than retail."

However, under the Efficient Market Hypothesis, any time you buy and sell securities, you're engaging in a game of chance, not skill. If markets are efficient and current prices always reflect all information, there's no way you'll ever be able to buy a stock at a bargain price.

Fama also asserted that the price movements of a particular stock will not follow any patterns or trends at all. Past price movements cannot be used to predict future price movements. He called this the Random Walk Theory -- stock prices move in an entirely random fashion, and there's no way to ever profit from "inefficiencies" in the price of a stock.

The end results of the Efficient Market Hypothesis and Random Walk Theory are controversial. If you can't predict stock prices, and picking stocks is really a matter of luck, how are we supposed to invest? And what are all those people on Wall Street doing, anyway?

Once you've resigned yourself to never beating the market, the Random Walkers say, you can be satisfied with matching the returns of the overall market. Instead of picking stocks or individual mutual funds, you should invest in the entire stock market. You can do this by investing in index funds, special mutual funds that are designed to allow you to match the returns of the overall market.