December 2nd, 2005

“Random Walks” and Stock Charting

A little personal history is order. I started charting stock prices when I was about to graduate high school — a long time ago. I eagerly awaited the newspaper each morning, with pencil in hand, and laboriously plotted the previous day’s closing prices on special “securities” graph paper (sheets 11″x18″ with grid lines of 5X8 … five days by eighth of a point, which is the way stock prices were quoted before the conversion to decimals). I carried my binder of charts to college, where I continued to plot closing prices on about 300 stocks …. nearly an hour-long pricess … as completely as I could.

There was no choice when it came to selecting a graduate business school; it was going to be the University of Chicago because I had just come across a journal article by Eugene Fama entitled “Random Walks in Stock-Market Prices”, a groundbreaking and, now, classic treatise. The paper appeared in the UofC Journal of Business in the spring of 1965 and Fama went on to become a leader in developing the so-called “efficient markets” hypothesis; his writings have stimulated a large volume of related research at Chicago and elsewhere. The paper (a pdf summary of the original paper can be accessed the the above link) concluded (my emphasis):

In sum the theory of random walks in stock-market prices presents important challenges to both the chartist and the proponent of fundamental analysis. For the chartist, the challenge is straightforward. If the random-walk model is a valid description of reality, the work of the chartist, like that of the astrologer, is of no real value in stock market analysis. The empirical evidence to date provides strong support for the random-walk model. In this light the only way the chartist can vindicate his position is to show that he can consistently use his techniques to make better-than-chance predictions of stock prices. It is not enough for him to talk mystically about patterns that he sees in the data. He must show that he can consistently use these patterns to make meaningful predictions of future prices.

And that is what I have been trying to do for the past 40 years. Graph paper and pencils have been replaced with graphing software. Waiting for tomorrow’s newspapers has been replaced with realtime market quotes. Fixed commission trading (e.g., $150 for a 3oo share 10 stock) has been replaced by “discount brokers” and $8 trades.

But my challenge remains the same: proving that being a chartist is not like being an “astrologer” while, at the same time, actively managing my portfolio to produce greater returns than available by investing in an index fund (i.e., having a positive performance relative to the S&P500 benchmark).

And now, through the invention of blogs, you can be the judge of whether charting experience and skill can outperform an “efficient” market.

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