Random Walk Part 2 – Does Any Asset Price Fit the Bell Curve?
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This is the second of my four-part empirical research into the fallacy of the random walk paradigm in investments. Part 1 focused on the failure of the random walk to depict the Dow Jones Industrial Average. In this article, I expand the study to include six diverse asset classes including large-caps (the S&P500), small-caps (the Russell 2000), emerging markets, gold, the dollar and the 10-year Treasury bond. Asset prices do not walk in tiny steps along an orderly bell curve, but often take giant leaps leaving chaotic turbulence behind.
What are the common features among seven widely diverse asset classes? Why are asset prices so hard to pin down by random walk or other analytical and descriptive models? What are the investment implications if asset returns do not fit the bell curves?
Part 3 will deal with its flaws in defining investment risk. Part 4 offers a new reward and risk framework alternative to the random walk paradigm. The new framework yields new insights on how to logically beat the S&P 500 total return.
Empirical evidence against the random walk model
In Part 1, I presented price return histograms of the Dow Jones Industrial Average from 1900 to 2016. In this paper, I extend the empirical research to six other assets. Detailed results are in the Appendix. Figure 1 summarizes the five-year return histograms (light blue bars) of seven asset classes – the DJIA from Part 1 and six other assets from the Appendix. No return histogram (light blue bar) has any resemblance to its corresponding random walk probability density functions PDF (dark blue curve). All random walk PDFs are unimodal (with a single central mean) with matching wings on both sides. All empirical distributions have multiple peaks with no central symmetry.
Common themes among different asset classes
1. None of the return histograms of the seven asset classes follows the random walk bell curve for periods longer than one day. The longer the return periods, the less bell-shaped they become. Real world prices do not follow a random walk.
2. Even for the one-day returns, all histograms show asymmetric fat tails. Random walk theorists have no explanation for them and treat them as anomalous statistical outliers.
3. All return distributions of time horizons beyond one year do not have a single mean and a definable variance. Random walk's mean-variance paradigm does not reflect reality.
4. Random walk's bell curve underestimates the probabilities of both large losses and gains beyond ± one standard deviation. This has dire consequences in risk management.
5. It is standard practice to scale returns and volatilities in different time horizons by the number of trading days and by the square root of trading days, respectively. Data show that neither return nor the volatility follows such scaling rules.
Why are asset prices so elusive for the theoreticians to capture?
1. Random walk is not the only model that fails to explain price behaviors. Power-laws, game theory, agent-based models, behavioral finance and adaptive market hypothesis are all incomplete theories at best. The rational beliefs equilibria model appears to have the potential for solving the asset-pricing puzzle but it is still too early to tell.
2. Why are prices so hard to pin down? The culprits are the agents involved. Unlike mindless pollens and particles that blindly obey physical laws, humans write their own rules, adapt to their own mistakes and adjust their actions to new encounters with a mix of unscripted rational and emotional responses.
3. Investors appraise prices from the perspective of an imagined future shaped by their past memories and current value judgments. These mental chain reactions transform their decision-making processes into highly complex systems. Our imagined future today can in turn create a new future that could then alter the current reality. The feedback loops continue in real time and exacerbate the already complex systems.
4. To model asset prices properly, economists must track all these nonlinear, multifaceted and interactive dynamics. By comparison, modeling the physical world is a trivial task.