Random Walk Hypothesis (RWH) vs Efficient Market Hypothesis (EMH)

Profiting from Gaps and Anomalies in the Stock Market

In 2021, I noticed that the Random Walk Hypothesis (RWH) and the Efficient Market Hypothesis (EMH) seem contradictory. It doesn’t make sense for something to be both random and efficient at the same time.

I figured out that RWH applies more to shorter timeframes, while EMH fits longer time horizons where stock prices align with business fundamentals. In the mid-term, there are gaps and anomalies caused by randomness, market sentiments, or even manipulations by operators that can be exploited for profits.

I developed a few strategies to identify these anomalies and back-tested them for the last 20 years. They’ve been working well for me, despite varying volatility and holding periods that no one can control.

Interestingly, I later learned about Jim Simons. In an interview, he mentioned the same contradiction between these hypotheses. He and his team exploited the market for 30 years, but their strategies are not publicly available for obvious reasons.

The Random Walk Hypothesis (RWH) suggests that stock prices move in a random and unpredictable manner. This means that past price movements or trends cannot predict future prices. According to RWH, each price change is independent of previous changes, making market timing or predicting price movements futile.

The Efficient Market Hypothesis (EMH) proposes that stock prices fully reflect all available information at any given time. According to EMH, it is impossible to consistently achieve higher returns than the overall market because stock prices already incorporate and reflect all relevant data. EMH comes in three forms:

• Weak form: All past market prices and data are fully reflected in stock prices, meaning technical analysis cannot beat the market.
• Semi-strong form: All publicly available information is fully reflected in stock prices, suggesting fundamental analysis cannot beat the market.
• Strong form: All information, both public and private, is fully reflected in stock prices, implying even insiders cannot beat the market.

But aren’t these two hypotheses contradictory? How can something be both random and efficient at the same time? And haven’t there been traders and investors who have made huge money in the market?

Both RWH and EMH offer valuable perspectives on market behavior, but they can be seen as subjective, especially when considering different time frames.

In the short term, stock price movements often seem random and unpredictable, aligning with the Random Walk Hypothesis. This is because short-term fluctuations are influenced by various factors, including market sentiment, news, and events, causing prices to move erratically.

Over longer time horizons, stock prices tend to align with the Efficient Market Hypothesis, reflecting the fundamental values of the companies. Business fundamentals, such as earnings, growth prospects, and economic factors, play a more significant role in driving stock prices over the long term.

In the mid-term, investors can often identify gaps and anomalies in the market. These inefficiencies can occur due to various reasons, such as planted news, manipulation, delayed reactions to news, misinterpretations of information, or temporary market sentiments. By spotting these anomalies, investors have the opportunity to make decent profits.

Let’s take an example of HDFC Bank, listed on the Indian Stock Market (NSE/BSE). Over the last three years, HDFC Bank’s profits have doubled. However, the stock price hasn’t moved much. This means there’s no strong fundamental reason for the stock price to remain stagnant while the company’s performance has improved significantly.

This situation creates an anomaly in the shorter term. Sooner or later, the market will recognize the improved fundamentals, and the stock price should adjust accordingly. This makes it a good opportunity to build a position in HDFC Bank, expecting the stock price to catch up with the company’s strong performance.

Please note: The example I shared here is for educational and learning purposes only. There is no suggestion or recommendation of any kind; please do your own research before investing or trading.

While the Random Walk Hypothesis suggests that short-term price movements are random and unpredictable, the Efficient Market Hypothesis indicates that long-term prices reflect all available information and business fundamentals. By identifying market inefficiencies in the mid-term, investors can capitalize on gaps and anomalies to achieve decent profits. Both hypotheses provide valuable insights, and understanding their relevance in different time frames can help investors make informed decisions.

If you loved this story, please feel free to check my other articles on this topic here: https://ankit-rathi.github.io/tradevesting/

Ankit Rathi is a data techie and weekend tradevestor. His interest lies primarily in building end-to-end data applications/products and making money in stock market using Tradevesting methodology.