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Widening the Random Walk

"A Random Walk Down Wall Street," written by Princeton economist Burton Malkiel, was first published in 1973.

It became, at the time, an instant classic. The Random Walk idea postulated, in effect, that prices of securities and financial assets of all types took the same path as a random walk by a human ambler.

In effect, prices are volatile.

The book had two lasting impacts. For individual investors, it laid the foundation, capitalized on by Vanguard Group, that active management of their investments was foolhardy. No one can predict the future. Passive strategies, such as index strategies, would produce superior results.

For professional investors and fund managers, the reason why prices resembled a random walk was because ... the market was efficient. All knowledge about a security was already embedded in the price. So the price was subject to movement, when new material information arrived.

Which, four decades later, is happening with incredible ferocity and velocity.

When markets closed Tuesday Oct. 26, there was near euphoria. Germany was going to back a serious, stout resolution of the European debt crisis. Securities prices and the indices that follow them moved up in leaps and bounds.

When markets closed Tuesday Nov. 1, investors felt they were staring into the abyss. Again. Greece, seen as possibly the most fiscally wayward member of the Euro zone, was going to put up the bailout up to a popular vote. Bye-bye Euro. Hello, drachma.

And watch out for ripple effect, worldwide.

Add to this the hyper-speed of high-frequency trading and the hyper-impact of ETFs, not around four decades ago.

At 11:38 a.m. last Tuesday, 5.73 million messages came across all live market data feeds. In a single second. Ergo, more than 300 million messages were exchanged in the full minute. All to be digested and acted on, immediately. In real time. Spawning more activity. More "random" walking.

That was the look into the abyss. And it was more than double the single-second peak on May 6, 2010-the day of the Flash Crash.

Now you have mutual funds that can be bought and sold within a trading day. They're called exchanged-traded funds. They often promise investors a return that is 3x, 2x, -1x, -2x or -3x of the return of an index or other benchmark (target) for a single day, such as ProShares promises.

ETFs already account for about 35% to 40% of stock exchange trading volume, according to Morningstar. And the creation of more shares, in large amounts, does not happen with some formal new issuance. That now occurs on demand (see "Creating or Redeeming ETFs on the Fly,'' p.1).

All of which means that the random walk down Wall Street is getting more and more random. And the randomness does get amplified at each turn. By design.

In fact, markets now are not so much driven by efficiency, as psychology.

Over time, in fact, analysts and investors have found that it's pretty hard to forecast who's solvent and who's not.

Who expected Lehman Brothers to go bust, in spring of 2008?

Who expected Greece to hit the wall in 2011?

Who knew how bad things were at MF Global?

Not surprisingly, Malkield includes in the 10th edition of "Random Walk" a discussion of ... behavioral finance.