Secrets Of Success: Simple lessons from a wise teacher
Saturday 30 July 2005
Most investors have little direct exposure to financial theory, and few seem to feel that they suffer very much as a result. The way it is presented in the standard text books is unexciting, to put it mildly. Even those - like MBA students - who feel they have to go through the process in order to advance their careers, rarely seem to come away with a profound understanding of the revolution in financial theory of the last 40 years.
Yet there has been a wave of theoretical advances in the way that we think about finance and investment since the late 1960s. In turn, this has completely transformed the way that financial markets operate. Way back then, to take one example, there was no financial futures market in which investors could hedge their risks. Now it is a multi-billion-dollar business that underpins the relentless growth of global capital markets and the consequent broadening of opportunities for millions of investors.
Way back then, there was no such thing, either, as an index fund, an innovation that has, whether they know it or not, materially improved the lot of millions of ordinary investors. Most importantly of all, there was only minimal understanding of what risk in financial markets was, and how it could be managed - not entirely surprising when we lacked basic reliable data on the behaviour of different asset classes over time. Now, however, we understand this issue a whole lot better, even if we cannot (and will never be able to) eliminate risk from our lives.
All three of these developments can be traced directly to some of the important advances in financial theory made since the late 1960s by groups of academics, mainly working in the United States. Allied to the widespread availability of computing power, their efforts mean, as successive Nobel Prize committees have acknowledged, that it is now possible for investors of all kinds to participate more safely in fair and liquid markets in a wide range of financial instruments that our forebears never had the chance to use.
As with other scientific advances, however, the problem is always how to convey what has been learnt to a wider audience. Perhaps the most effective way, for those with a hunger to learn is through the medium of histories that present the development of some of the core ideas in modern finance theory as narratives involving the leading personalities.
Some years ago, I mentioned in this context Peter Bernstein's book Capital Ideas, which remains a highly readable survey of the way that finance theory has developed.
Now, at long last, comes a second book that can also be recommended as readable to those with the intellectual curiosity to pursue financial theory. It is a history of the life and thinking of the iconoclastic American theorist, Fischer Black, who tragically died in 1995 only months before standing to receive a Nobel Prize for his part in the development of a formula that solved the riddle of how financial options should be priced.
The Black-Scholes formula, named after Black and his collaborator Myron Scholes, is a classic example of how theory can produce dramatic changes in the way that the world works. The puzzle of how to value options correctly had defeated many clever minds before it was finally solved through a classic piece of counter-intuitive thinking (the price of options is a function of the volatility, not the expected return, of the underlying asset).
Although the formula is not a perfect predictor of option prices, it is robust enough to underpin the creation of a huge market in financial options that operates around the world today. More importantly, it has proved to have enormous practical value in understanding a wide range of decisions, both financial and non-financial.
The man who helped to crack the code, it turns out, was a complex but fascinating oddball who defied easy categorisation and, unlike most academics, proved equally at home in both academia and the business world. After Chicago and MIT, he finished his career as a partner in the powerful investment bank Goldman Sachs.
A loner by instinct, who never found communication with others easy, Black's forte was in applying his brainpower to solving complex problems. As with options pricing, his approach was to focus on simple, powerful (and often controversial) models to unlock the problem at hand.
As his new biography makes clear, the range of Black's interests was unusually wide, extending far beyond financial formulae into the broader areas of investment management, accounting and macroeconomic policy.
Models that carry his name are still used in commodity markets, in the futures markets and for asset allocation decisions at investment institutions. His concept of "noise" in trading markets helped to transform the way large banks such as Goldman Sachs run their trading operations.
Yet Black also had radical ideas that look smart now, but were way ahead of their time. For example, he was one of the first to suggest pension funds should match their liabilities with bonds rather than rely on equities to produce higher, but riskier, returns.
He also wanted accountants to use "creative accounting" deliberately so as to come up with a single adjusted earnings figure that would help investors determine the worth of a firm's shares with confidence. He also thought, controversially, that central banks on the whole did little good by intervening in financial markets, except to provide profit opportunities for smart investors.
Remarkably, for a Nobel Prize winner and a man so highly regarded in academia, Black never took a formal course in either economics or finance, something that his biographer, Professor Perry Mehrling, argues was probably one of the secrets of his success. "The thing that is the most fun is coming up with something that seems ridiculous when you first hear it, but seems obvious when you're finished," is how Black summed up his philosophy. It made him a stimulating figure, but one whom some thought too irresponsible.
But why, you might ask, does all this matter to investors? Primarily, in my view, because modern finance theory emphasises that the things investors should be thinking about - how much risk to take, how much money to invest abroad, how to allocate assets in times of uncertainty - are not, in fact, the things that most of us do spend our time thinking about.
We all want sure-fire answers when there are none available. What Black and others have really taught us is that, as the future is unknowable, we should spend as much time thinking carefully and clearly about how to minimise risk effectively, rather than simply seeking the highest available return.
'Fischer Black and the Revolutionary Idea of Finance' by Professor Perry Mehrling will be published by John Wiley and Sons on 17 August, priced £19.99
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