The Genius of Finance -- Book Review of Fischer Black and the Revolutionary Idea of Finance
Fischer Black is best remembered for being the "Black" of the Black-Scholes option pricing model -- an intellectual achievement that, along with Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM), heralded the birth of quantitative finance. But, as Perry Merhling masterfully reveals to the readers of his book, Fischer Black considered the Black-Scholes formula -- which earned Myron Scholes and Robert Merton Nobel Prizes (which would have been awarded to Fischer Black had he not died of cancer in 1995) -- to be a relatively minor component in his overall views of both the financial world and the world at large.
Unlike the vast majority of academics and practitioners, he was not slavishly loyal -- with the quasi-exception of his quixotic CAPM and equilibrium based philosophy, which cannot easily be pigeonhold into any stereotypical category -- to any particular school of thought or to any particular model, even ones' named after him. Instead, the framework with which he analyzed, and by which he even lived his all too brief life, was not any particular school of thought in finance but to finance itself. Fischer Black approached finance, not only as a science, but also as an art -- a way to express oneself and be creative.
To Fischer Black, finance was a port or a lighthouse in the storm; finance was a way to negotiate through the swirling currents and buffeting winds of risk and return. To Fischer (perhaps under the influence of one of his teachers, Harvard philosopher/logician W.V.O. Quine), finance was a language -- in fact, one of his proudest achievements was to create, for his students at MIT, a dictionary of finance (the definitions reflecting his unique views on finance) to provide a semantic schema for this language -- a way to formulate ideas and express them in a world full of uncertain gains and losses.
The book also reveals Fischer Black to have been a man of paradoxes and unconventionality. In his personal life, his daily routines were so invariant and downright boring that it would have been easy to predict what he had for lunch on a particular day (plain broiled fish and a baked potato with no butter), yet there were significant aspects of his life that were bohemian and extremely unconventional. He was capable of great generosity and humility, yet his lack of social graces could be off-putting even to those most closest to him. He was an academic that wound up as a partner at Goldman Sachs; he was a practitioner that did substantial research in finance on his own time and dime with no discernible intention to gain professional currency or glory.
The most ironic paradox was the fact that, although Fischer Black obtained a PhD in Applied Mathematics from Harvard, he could not solve the Black-Scholes stochastic differential equation using conventional methods from math and physics (he arrived at a solution through a kind of 'back-solving' method where Black and Scholes applied CAPM logic assuming a zero-beta security; Robert Merton later supplied a more straight-forward proof). This might be a sign to some that Fischer Black wasn't good at math (despite the PhD). I draw the opposite conclusion: If one views 'math' as being mostly about calculation or applying textbook methods in textbook ways, then Black wasn't a good mathematician. But, if one views mathematics as being, at heart, about applying logic and abstract thinking to creatively solve problems and prove propositions, then what Black did was brilliant mathematics -- arriving at an imaginative solution, using accessible and relatively simple tools at hand, to what was then a difficult conundrum that had stumped other brilliant thinkers.
Fischer Black's unconventional approach to life can best be summed up by his political preference during the 1980 presidential election. Rather than supporting Reagan, who his Chicago colleagues likely favored, or Carter, who his MIT colleagues would have been warm towards, Fischer supported the third party candidate, John Anderson!
His path to finance was, not surprisingly, an unconventional one. Fischer Black started his intellectual and professional career, not as an economist, but as a computer scientist and a technology consultant. His early career saw stints as a consultant at BBN, a firm that played a crucial role in the development of the Internet, and at Arthur D. Little.
His early career as a computer scientist (this was before there really was such a job description) had a lasting impact -- both in how he lived his life and in his approach to the the practice of finance when he latter joined Goldman Sachs -- on Fischer. Fischer's research in computer science was focused on artificial intelligence, but, whereas most AI researchers explicitly or implicitly centered their research on how machine intelligence could substitute for human intelligence, Fischer focused on the interaction between man and machine -- specifically, how machines could be used to enhance human intelligence. Fischer held onto to the idea that machines could enhance and supplement human intelligence and was skeptical that machines could truly replace man.
This led to another interesting paradox that was on display when Fischer joined the ranks of Goldman Sachs : On one hand, Fischer did not use the latest in computer technology for his personal work; his computer had a monochrome screen when color screens were widely available and probably did not have the latest in graphical user interfaces. In fact, he was (in)famous for relying on a paper-based filing system (whose only technological connection was that Fischer used a very simple organizational software called ThinkTank to catalogue the cards and notes) to memorialize his musings. Yet -- as Emanuel Derman, in his autobiography My Life as a Quant: Reflections on Physics and Finance, noted -- Fischer went to great lengths to insist on a user friendly interface for computerized valuation tools and trading systems for Goldman Sachs traders. Furthermore, Fischer had the foresight to predict automated trading systems and exchanges decades before they came into wide-spread use and acceptance.
It was at Arthur D. Little that he came into contact with CAPM and the pioneering work on quantitative finance done by Robert Samuelson, Harry Markowitz, William Sharpe, and, most significantly for Fischer, Jack Treynor. It was CAPM, and the closely related idea that prices tend toward equilibrium, that served as Fischer Black's map and compass on his many adventures in finance and economics as a professor of finance at the University of Chicago and at MIT as well as at Goldman Sachs.
In the field of finance, Fischer's contributions and musings are too numerous to recount here, but he made important contributions (or could have if some of his thoughts had been more widely circulated) to almost every field of finance, including financial and managerial accounting, tax accounting and law, corporate finance, international finance, and investment management. In direct opposition to the 'efficient market hypothesis' school of thought, Fischer was one of the first to recognize the influence of noise traders on financial markets. He went so far as to argue that the Black-Scholes model -- which initially would have provided 'signals' (valuable information) in the marketplace -- had contributed to some of the increasing noise in the financial markets. He further demonstrated an ability to sacrifice ego for the sake of advancing knowledge and practice when, at Goldman Sachs, he encouraged the use of discrete, tree-based option pricing models by John Cox, Stephen Ross, and Mark Rubenstein (with some inspiration by William Sharpe) over the Black-Scholes-Merton model because the tree model was more flexible.
Whereas his contributions to finance, including his challenge to conventional wisdom, was, at the very least, met with general acceptance by the financial community, Fischer's forays into other parts of economics -- especially macroeconomics -- were met with a great deal of skepticism if not downright hostility. His views of the business cycle and monetary theory were considered to be almost blasphemous by some -- his 'monetary theory' basically did away with money altogether! (At least, the convention notions of money.) Fischer's theories of macroeconomics were based on his quixotic views of CAPM and equilibrium and did not fit in either with the Keynesian (or neo-Keynesian) or Monetarist camps; Fischer's views could best be called the 'finance theory of macroeconomic business cycles.' In fact, he had been a professor at the 'holy cities' of both camps (Chicago for Monetarists and MIT for neo-Keynesians) and made little headway with either group in converting them to his ideas. As Perry Mehrling correctly points out, time seems to be on Fischer's side, and, as recent trends in the awarding of Nobel prizes to macroeconomists with views similar to Fischer's seem to suggest, Fischer's views may step out of the intellectual wilderness and become mainstream views in the near future.
In both his forays into finance and economics, as well as in aspects of his personal life, the idea of equilibrium, which Fischer saw as being at the core of his CAPM-based philosophy of life, was of critical importance to Fischer Black both intellectually and as a man. But his approach to economic, financial, and other types of equilibrium was, as in other aspects of his life, paradoxical. On one hand, his devotion and laser-like focus on general equilibrium would have put even the most ardent Chicago-school economist to shame. Yet, Fischer's idea of equilibrium was not the static or smooth one that is typical of economists of any school; Fischer inherently viewed equilibrium as being dynamic and jumpy.
To Fischer Black, equilibrium was a goal of life and not necessarily a fixed state of being. Rather than staying in place or being completely aimless, Prices will move from equilibrium towards a new equilibrium. In other words, equilibria serve as attractors to prices but they were by no means the unchanging and unerring entities as they were in the minds of many economists. Moreover, the idea of equilibrium, e.g., finding the right balance between risk and return, was more of a guiding philosophy and an analytical framework to Fischer rather than some unbending rule that one simple-mindedly tied oneself to.
Fischer's more flexible attitude toward equilibrium allowed him take the right kinds and amounts of risks. Fischer took a great deal of intellectual risks with his research because he, rightly, saw that the returns to him were well worth the risk. Fischer, however, refused to take less-than-wise financial risks. For example, although he had been offered a position with a great deal of financial benefits to take part in the mis-adventure of LTCM -- an offer that both of his option pricing colleagues, Myron Scholes and Robert Merton, took to their regret -- Fischer rejected their offers. In Fischer's mind, LTCM was "loading up on risk." It turned out, after his death, that he was absolutely correct.
Fischer's willingness to challenge conventional wisdom (and foolishness) was perhaps best displayed in his famous "Fifty Questions" in finance courses at Chicago and MIT. There he was in his element; like a master painter working at a canvas or a poet tapping away at a typewriter, Fischer Black used his classes -- with the aid of his "Fischer Black's Glossary for Finance" -- to explore the language of finance. The questions were usually the same from class to class, but the answers were often radically different. Such is the price of genius.