Flow of Funds Accounts Limitations : Random Walk Fallacy Limitations on Flow of Funds Accounts : continued

Flow of Funds Accounts and the Random Walk Fallacy

Sector Definitions Limit Analysis

Although the behavior and motivation of households is different from that of corporate issuers, the behavior of every group within the household sector is hardly the same.

Some categories of individual investors are buyers, while other are sellers.

We know that the Super-Rich have different motivation than the Non-Rich.

If the Federal Reserve were to divide the household sector by wealth categories, this would be useful, but, until then, we work with what we have.

Focus On Player Differences

There is obviously a commonality between members of the household sector that differs from the commonality between members of, say, the corporate sector.

  • For example, households are made up of individuals that are born and die, pay individual income taxes, and have reasons for living other than the profit motive.
  • Corporations, in contrast, can be closed down or go bankrupt, but have no biological life span.
  • Corporations pay income taxes according to a different schedule than households and have no interest in saving for their old age.

The instrument tables show the net effect of purchases and sales of one sector on other sectors.

Fund Flows Are Not Random

For fifty years, the Federal Reserve has been compiling flow of funds accounts. There never has been a year, or even a quarter, in which flows between sectors have all been zero.

Nor have the flows between sectors fluctuated in a random fashion, averaging to zero over time.

Instead, flows between sectors have shown behavior that has persisted for long periods.

Often these patterns can be related to price trends of certain categories of securities.

Therefore, although the sector breakdown in the Federal Reserve flow of funds accounts may be imperfect, the system is useful for purposes of explaining market trends.

The Random Walk Fallacy

In 1973, Burton Malkiel wrote 'A Random Walk Down Wall Street', claiming that stock price movements were random and that it was impossible to beat the market by analysis.

This 'Random Walk Theory' had an enormous impact on investment thinking over the last generation, leading to the proliferation of index funds and contributing to widespread acceptance of the Efficient Market Hypothesis and Modern Portfolio Theory.

There are many logical fallacies in the Random Walk Theory, including the fallacy of composition, illicit major, untestability, limited scope, limited depth, and various fallacies of definition.

There are many logical fallacies in the Random Walk Theory

However, two examples serve to illustrate the point:

  1. Although successive market price changes, upon mathematical testing, appear to be random, it does not follow that there is not some knowable cause that would completely explain the price changes. The test only proves that the testor does not know what such a cause might be.
  2. For example, let us suppose that price changes were, in fact, dictated by a gnome in a black box using the successive digits of the number pi to determine the next price movement. If one was unaware of the existence of the gnome and the secret mechanism, it would seem that the price changes were random. However, once one discovers the trick, prices could be predicted with 100% accuracy.
  3. This is not to say that there is a gnome in a black box driving prices on Wall Street — only that Professor Malkiel did not know what the mechanism might be and did not, in fact, seriously search for a cause.
  4. It is possible (and even probable) that there are random events effecting order flows to the securities markets that joggle successive prices in an unpredictable fashion, while there are greater forces that effect the basic trend of the market.
  5. For example, a ball rolling down hill may have its course altered in a random fashion by pebbles it encounters along the way, while still continuing on its downward course. To say that it is impossible to predict the final destination of the ball because of the wiggles in its downward path would be absurd, but that is exactly the logic used by Professor Malkiel.
  6. Furthermore, we know that as possible explanations for market prices, Professor Malkiel looked only to fundamental analysis and technical analysis. Capital Flow Analysis was virtually unknown in 1973. John Dawson, the leading expert on flow of funds analysis, has said that "Flow of funds analysis is an undefined and partially hidden field of study". (See: "Flow of Funds Analysis: A Handbook for Practitioners ")
  7. Although Professor Malkiel recognized the long-term upward movement in stock prices, his theory failed to attribute a cause consistent with the idea of a random walk.
  8. As we have seen, even a casual examination of flow of funds accounts indicates that capital flows are not random. Since it is logical that capital flows are connected to security price trends, it follows that these flows might be the 'gnome in the box' about which Professor Malkiel knew nothing.

As a capital flow analyst, you should be aware of market fallacies such as the Random Walk, the Efficient Market Hypothesis, and even the flaws in Modern Portfolio Theory, because your conclusions are likely to be challenged by many people who believe these theories.

Motivated Flows Drive Prices

If the purchases of equities by members of the household sector were equal to the sales of equities by other members, we might expect the household sector to have no discernible impact on the price of equities.

[There could be sub-sectors within the household sector that are influencing prices, 'below the radar' of the national flow of funds accounts.]

However, if the household sector was a net buyer or net seller of equities, then we would expect that the household sector would have a positive or negative effect on the price of equities.

Furthermore, the larger the net flows of the household sector compared to the net flows of other sectors, the greater the importance of the household sector in explaining price movements in the equity markets.

By knowing the relative size of the net flows of the various sectors with respect to a specific type of security, we have a starting point for our analysis.

We must remember, however, the Motivation Axiom. It is not only the size of the flows but the relative motivation of the players that cause security prices to rise and fall from quarter to quarter.

Summing Up

We start Capital Flow Analysis by reading the flows of instrument tables, noting the behavior of those sectors that have the largest flows and that have flows that seem to be driving prices.

This site is organized so as to make it easy to identify the significant flows that drive prices in securities markets.

In explaining these flows, we start with the premise that flows are based on differences between the sectors and it is these differences that provide motivations that drive markets.


Before proceeding, check your progress:


Federal Reserve flow of funds accounts show:
Choice 1 Asset transfers between rich and poor.
Choice 2 Stock buybacks by utility companies.
Choice 3 Net equity purchases by mutual funds.
Choice 4 Cash flows of the super-rich.
Over many years, U.S. flow of funds accounts have demonstrated:
Choice 1 Purely random variations in capital flows.
Choice 2 Many periods with zero net flows.
Choice 3 Proof of random walks in stock prices.
Choice 4Trends and patterns of consistent behavior.
In Capital Flow Analysis, we expect security price trends to be driven primarily by:
Choice 1 Large flows of motivated sectors.
Choice 2 The intrinsic value of securities.
Choice 3 Random, unknown forces.
Choice 4 Profit taking by speculators.

Investment Tutorial: Capital Flow Analysis  learning module : continued >

Suggested Reading on limitations in flow of funds accounts and the random walk fallacy.
"A Random Walk Down Wall Street", 7th edition, Burton Gordon Malkiel

First published in 1973, Professor Malkiel (Princeton University) recommends buying index funds, rather than trying to select stock based on fundamental analysis.

Flow of Funds Books

Flow of Funds
National Income and Product Accounts

Capital Market Operations Books

Corporate Takeovers
Clearings and Settlements
Bubbles and Speculation

American Financial History Books

Crash of 1929
Crash of 1987
J. P. Morgan
Chase Manhattan Bank
Socialism in the U.S.
Wall Street
The Gold Standard

International Capital Markets Books

Latin American Financial Crises
Asian Financial Crises
City of London
Japanese Financial Markets
Emerging Markets
European Financial Markets
Chinese Financial Markets
Brazilian Capital Markets
Thai Capital Markets
Korean Capital Markets
International Capital Markets

Economics, Ethics, and Morality Books

Morals, Ethics, and Capitalism
Accounting and Ethics
John Maynard Keynes
American Morality
Milton Friedman
Ayn Rand
Behavioral Science
External Links on limitations in flow of funds accounts and the random walk fallacy.
Federal Reserve Board : Federal Reserve Guide to the Flow of Funds Accounts. [Return]
Keynes' Game Of Musical Chairs : 'The General Theory of Employment, Interest, and Money', Chapter 12. The University of Adelaide (ebook) [Return]
Random Walk Theory : 'Financial Concepts: Random Walk Theory', Investopedia.com. [Return]
Efficient Market Hypothesis : 'The Efficient Market Hypothesis and the Random Walk Theory', Investor Home. [Return]
Modern Portfolio Theory : 'Portfolio Theory', Risk Glossary.com [Return]
Logical Fallacies : 'Stephen's Guide to Logical Fallacies', Stephen Downes. [Return]
Fundamental Analysis : 'Intro to Fundamental Analysis', Investopedia.com. [Return]
Technical Analysis : 'Technical Analysis: Introduction', Investopedia.com. [Return]

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