Random Walk Theory: What It Is and 5 Reasons it Supports Investing in Low-Cost Index Funds

Investing in the stock market can be daunting for many aspiring and even experienced investors. With countless options available, it can be overwhelming to determine the best approach to building a well-diversified portfolio that will give you the optimal return depending on your investment objective.
One prominent school of thought that has gained significant traction in recent years is the "Random Walk Theory." But what is it exactly? In this post, we will explore what this theory is all about, as well as how it supports investing in low-cost index funds.
So What on Earth is Random Walk Theory?
To simplify, Random Walk Theory is a concept that has been around since the mid-1900s. Fundamentally, the theory suggests that stock prices move randomly and that it is impossible to predict their future movement accurately.
Furthermore, the theory is based on a much-debated economic framework called the "Efficient Market Hypothesis," which asserts that all available information about a company is reflected in its stock price, making it impossible to outperform the market consistently over a sustained long period. Hence, the most optimal option is to invest in prominent index-tracking funds, better known as "market benchmarks," rather than trying to beat the market.
With this in mind, here are five ways that the Random Walk Theory supports investing in low-cost index funds:

1. Efficient Investing

The Random Walk Theory proposes that it is difficult to outperform the market consistently, as stock prices reflect all available information. This means that most actively managed funds will fail to generate higher returns than the market over the long term.
Thus, by investing in low-cost index funds/ETFs, investors can gain exposure to a diversified portfolio of stocks that aim to match the market's performance.

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2. Diversification Achieved

Since the Random Walk Theory suggests that it is impossible to predict individual stocks' future movement accurately, by investing in a low-cost index fund/ETFs, investors gain exposure to a diversified portfolio of stocks that aim to match the market's performance. This diversification then helps mitigate the inherent risks associated with investing in individual stocks.

3. Lower Fees - Higher Return

One of the significant advantages of investing in low-cost index funds is the lower fees compared to actively managed funds. Since index funds/ETFs track a market index, they require less research and trading, resulting in lower overall costs.
Over time, these lower fees will compound and significantly impact an investor's overall returns detrimentally.

4. Superior Long-Term

Moving forward, by investing in low-cost index funds/ETFs, investors can adopt a long-term investment strategy that aims to match the market's performance over time. This approach can help investors avoid the common pitfalls of short-term thinking and emotional investing.

5. Passive Investing is the Way to Go!

Lastly, investors will be able to adopt a passive investing approach that aims to match the market's (benchmark) performance. This approach can help investors avoid the risks associated with active investing, such as managing risk, "style drift," and, of course, the often high fees.

Conclusion

In a nutshell, the Random Walk Theory suggests that trying to outperform the market consistently is not wise and often a waste of time, effort, and money. This inadvertently makes low-cost index funds/ETFs an attractive investment option for many investors. Furthermore, investors gain exposure to a diversified portfolio of stocks that aim to match the market's performance, all while keeping fees as low as possible by leveraging a long-term passive investing approach.
Nevertheless, it is paramount to always do your research first before investing in any asset. Thankfully, there are now sophisticated data visualization tools, such as ETF Insider that help you with your due diligence. With this, you can precisely see the composition and weight of your chosen fund/s, granting you the ability to tailor your investment to your own goals while looking out for you not to be overexposed to certain assets and industries.
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