Some academics have argued that stock movement is random, and that investing in the stock market is nothing but a gamble. These people hold that even if you buy a stock that is in a well-defined up-trend, it is just as likely to trend down as up after you purchase it. Professional traders, on the other hand, believe there are inefficiencies in the market. They hold that it takes time for stocks to move up or down in order to reflect the changing realities of business. They would also argue that stocks often exhibit momentum in their adjustments to those changing realities.
The problem with the former position is that it does not adequately account for the experiences of traders. For example, a trader will buy a stock that is in a “setup” configuration because there is a high probability that the stock will surge in price shortly after the stock’s pattern completes a setup. Much more often than not, it does. Traders buy stocks that are trending because, more often than not, the trends continue and they will be able to sell at a higher price. That could only be explained by the idea that a trend has “momentum.”
However, let us assume that the “random-walk” theorists are correct. Assume that the odds of a stock rising or falling are always 50-50. Even if we agree to that, no one would argue that when a stock moves it can only move a defined amount. That is, to be consistent, the “random walkers” must also assume that the extent of a move up or down is also random. Some stocks will rise or fall only 1% (more or less) and others will rise or fall 25% (more or less).
If we assume that whether a stock rises or falls and that the percentage gains or losses of any extended move are all random, then we would suggest that it is still possible to be a fairly consistent winner in the stock market. The following is just one example of how it can be done. Let’s assume that you consistently sell any stock that drops 3% below the highest low the stock reaches after its purchase. This will be too active for some, but it will illustrate the point. Let’s say that a stock rises to a gain of 3% at its high point and at that moment its low price is also at a high (let’s assume it is up 2%). Then the stock drops so that its low price is 3% below its highest level. You would therefore sell the stock for a 1% loss (if you sold at the low). Assume another stock’s low price rises a maximum of 12% before declining 3% from that level. That one will be sold for a 9% gain. Since the percentage gains before a 3% drop must be assumed to be randomly distributed, then there will be a significant number of stocks that rise 5%, 10%, 15%, or more after their purchase. If no stock is allowed to decline more than 3%, then 3% is obviously the maximum amount you will lose on any position. On the other hand, the upside has no limit. That means you will sometimes make gains of 2%, 7%, 12%, or even more on some of your trades. The result is that, over time, you are much more likely to make a profit than suffer a loss. That has been the experience of expert traders.
The bottom line is that even if stocks moved in an absolutely random way, you could still be a winner over extended periods. The idea that you couldn’t be a winner is based on a scenario in which a person buys a portfolio of stocks and does not sell anything until some indefinite future when the portfolio is liquidated. In other words, the positions are not being managed and a gain in one stock is balanced by a loss in another. The idea is that you not only buy at a random price, but you also sell at a random price. There is no strategy here. However, we have seen that by proper portfolio management and the application of a sound strategy, it is possible to effectively “rig the game” in your favor, even if stock movements were purely random.
By Dr. Winton Felt
Copyright 2015, by StockDisciplines.com a.k.a. Stock Disciplines, LLC.