Efficient Market TheoryThe basic facet of random walk proponents is the efficient market hypothesis (EMH). The EMH idea states that all known information is already priced into a security's price structure. Therefore, no known information can help an investor gain an edge over the market. Additionally, this hypothesis includes the idea that all future news events are unpredictable and therefore one cannot position themselves in a particular security on expectation of an expected outcome to an upcoming event.
Fundamental AnalysisFundamental analysis is a study of a company's current situation in regards to its potential for both sustainability and as well as future growth. A fundamental analyst may decide to purchase a stock if he or she sees that a company has a strong balance sheet with low debt and above average earnings per share growth. These analysts would disagree with the efficient market theory belief that one cannot use this known information to make an investment decision regarding potential future price performance.
Technical AnalysisTechnical Analysis revolves around the belief that investor behavior repeats itself over time. If one can recognize these patterns, he or she can benefit from them by using them to potentially predict future price movement. The most basic of technical analysis is support and resistance. An example of support would be if a stock has been trading sideways in the $20 range for several months and then starts to move higher. The $20 range may act as a support area for any near-term correction. The logic here is that the $20 range represents the collective decision of many investors to have purchased shares in that area. A return to the $20 range will only put them back at even to the point at which they purchased their shares.
Technical analysts believe that investors are not likely to sell unless a significant break below that area occurs. The longer the time period over which a support area develops, the more investors it represents, and hence the stronger it may prove to be. A support area that only developed for a day or so will likely prove insignificant as it does not represent many investors. Resistance is the opposite of support. A stock that had been trending just below $20 for a period of time may have trouble breaking above this area. Again, technical analysts would argue that the reason is human behavior. If investors have identified that $20 is a good selling area for either booking profits on existing long positions or initiating new short positions, they will continue to do so until the market proves otherwise. It is important to note that once support is broken it may become resistance and vice versa.
Of course, the ideas of support and resistance are only guidelines. Nothing in the market is ever guaranteed. Prudent investors always use a risk management strategy to determine when to exit a position in the event the market moves against them.
A Random Walk
Random walk proponents do not believe that technical analysis is of any value all together. In his book, "A Random Walk Down Wall Street", Burton G. Malkiel compares the charting of stock prices to the charting of the results of a series of coin tosses. He created his chart as follows: If the result of a toss was heads, a half-point uptick was plotted on a chart; if the result was tails, a half-point downtick was plotted. Once a chart of the results of a series of coin tosses was created in this fashion it was postulated that it looked very much like a stock chart. This led to the implication that a chart of stock prices is as random as a chart depicting the results of a series of coin tosses.
To stock market technicians, this claim is not a true comparison because by using coin flips he altered the input source. Stock charts are the result of human decisions, which are far from random. Coin flips are truly random as we have no control over the outcome; human beings have control over their own decisions. .
ConclusionThe debate between those who believe in an efficient market and those who believe that the markets follow a somewhat cyclical path will likely continue for the foreseeable future. Perhaps the answer lies somewhere in between. The markets may indeed be cyclical with elements are randomness along the way.
Fundamental AnalysisFundamental analysis is a study of a company's current situation in regards to its potential for both sustainability and as well as future growth. A fundamental analyst may decide to purchase a stock if he or she sees that a company has a strong balance sheet with low debt and above average earnings per share growth. These analysts would disagree with the efficient market theory belief that one cannot use this known information to make an investment decision regarding potential future price performance.
Technical AnalysisTechnical Analysis revolves around the belief that investor behavior repeats itself over time. If one can recognize these patterns, he or she can benefit from them by using them to potentially predict future price movement. The most basic of technical analysis is support and resistance. An example of support would be if a stock has been trading sideways in the $20 range for several months and then starts to move higher. The $20 range may act as a support area for any near-term correction. The logic here is that the $20 range represents the collective decision of many investors to have purchased shares in that area. A return to the $20 range will only put them back at even to the point at which they purchased their shares.
Technical analysts believe that investors are not likely to sell unless a significant break below that area occurs. The longer the time period over which a support area develops, the more investors it represents, and hence the stronger it may prove to be. A support area that only developed for a day or so will likely prove insignificant as it does not represent many investors. Resistance is the opposite of support. A stock that had been trending just below $20 for a period of time may have trouble breaking above this area. Again, technical analysts would argue that the reason is human behavior. If investors have identified that $20 is a good selling area for either booking profits on existing long positions or initiating new short positions, they will continue to do so until the market proves otherwise. It is important to note that once support is broken it may become resistance and vice versa.
Of course, the ideas of support and resistance are only guidelines. Nothing in the market is ever guaranteed. Prudent investors always use a risk management strategy to determine when to exit a position in the event the market moves against them.
A Random Walk
Random walk proponents do not believe that technical analysis is of any value all together. In his book, "A Random Walk Down Wall Street", Burton G. Malkiel compares the charting of stock prices to the charting of the results of a series of coin tosses. He created his chart as follows: If the result of a toss was heads, a half-point uptick was plotted on a chart; if the result was tails, a half-point downtick was plotted. Once a chart of the results of a series of coin tosses was created in this fashion it was postulated that it looked very much like a stock chart. This led to the implication that a chart of stock prices is as random as a chart depicting the results of a series of coin tosses.
To stock market technicians, this claim is not a true comparison because by using coin flips he altered the input source. Stock charts are the result of human decisions, which are far from random. Coin flips are truly random as we have no control over the outcome; human beings have control over their own decisions. .
ConclusionThe debate between those who believe in an efficient market and those who believe that the markets follow a somewhat cyclical path will likely continue for the foreseeable future. Perhaps the answer lies somewhere in between. The markets may indeed be cyclical with elements are randomness along the way.
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