Don’t be Fooled by Random Walk

This lesson discusses Theory of Random Walk. The video introduces discusses Stochastic and Markov process to understand the underlying Brownian motion. Learn about Indifference Curves and Efficient Frontier. 

What is Theory of Random Walk?

The Theory of Random Walk for securities states that successive changes in individual securities will be independent. The future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers.  To understand the theory of random walk lets begin with the Stochastic Process. Any variable whose price changes over time in an uncertain manner follows Stochastic Process. Markov process is a type of stochastic process where only the current value of a variable is important for predicting the future-follows the weak form efficient markets.

Video : The middle Road

Brownian Motion “The Wiener Process”  

Continuous time stochastic process

• It’s a particular Markov Process
• Independent increments
• Process over the finite time is normally distributed, variance increases linearly over time

Efficient Concept and Assumptions

Any asset or portfolio is efficient if it offers higher expected returns for the same or lower risk. Investors consider investment alternatives through probability distributions of expected returns over different holding periods

Fig: Efficient Frontier | The middle Road 

• Maximize one period expected utility and these curves demonstrate diminishing marginal utility of wealth