As the notion in which Black invested so much intellectual energy was the capital-asset pricing model, that may explain why he is comparatively ignored today. After all, some of you groan, why should we take seriously anyone so unworldly as to give time and credence to the 'cap-m', a simplistic idea that died during the financial crisis of 2008 and was buried beside its close relative, the equally naive 'efficient-market hypothesis'? True, there was something unworldly about Black; a touch of the Mr Spock - kindly, yet too ruthlessly logical for human tastes. Despite that - perhaps even because of it - we should pay more attention to what he said because it helps explain how investors operate.
Recall that in its abstract the cap-m says just two things: first, that investors get compensated for saving their capital rather than spending it; second, that they get rewarded for taking risks.
This model of investing is useful because it is so simple. That we are compensated by the time value of money for saving should be uncontentious, with the only point of discussion worth asking: which interest rate should we use? Yet there are occasions - now, for example - when even the time value of money is distorted by outside agencies - usually government treasuries or central banks - so that interest rates don’t reflect the financial markets’ best guess for future inflation. This implies there is risk even within what is supposedly risk-free and it reflects a key point for Black - that unproductive distortions occur when things stop the risk/return trade off that is at the heart of cap-m from taking effect. Those things are usually bad policies, bad regulations or badly-designed contracts and sometimes blind ignorance. Whatever, they disturb the balance that buyers and the sellers of risk would otherwise find.
Then there are the rewards - at least usually - for taking on risk. 'Risk', of course, is a generic term for everything that's unknown and unknowable. And that's the trouble - there are so many factors that might mess up an investment that an investor can't know them all. And if he can't know them, then how can he put a price on them? And if he can’t price them, then why is he investing in the first place? The doubts and uncertainties crowd in so violently that Black questioned why investors invest at all.
That, indeed, was a puzzle; especially when framed in the terms, why do traders trade so much? In Black’s perfect world there would be little trading; just investors buying a market portfolio and adjusting their borrowing and lending as they became more or less bullish. The real world was nothing like that - a frenzy of activity and a cacophony of noise.
There were 'noise' traders everywhere; a rabble who bought and sold on the back of little more than tittle tattle. And amongst them - and far fewer in number - were 'information' traders, who dealt when they discovered significant new information. However, the difficulty was that even an information trader did not know whether he was trading information or noise, and occasionally a noise trader would find information. This was - and is - good and bad. Good because excessive trading helps make financial markets liquid (ie, it is easy to buy and sell), but bad because it distorts prices.
But that still does not answer the question: why is there so much trading? Black's logical mind struggled with that one, just as it struggled with a similar teaser - why do companies pay dividends? Any MBA student will tell you that tax laws in the UK and US render dividends inefficient. If a company wants to reward its shareholders, it should use share buy-backs rather than dividends. Yet most listed companies pay dividends regularly and there is a real kerfuffle when a pay-out is trimmed or axed.
In the end, Black solved both puzzles with the same answer: it happens because someone likes it. Companies pay dividends because investors like getting the cash and - more important - traders trade because it's fun.
That's not as inconsequential as it sounds. True, in Mr Spock mode, Black would not have natural empathy with a red-blooded trader (perhaps more with a cold-blooded one). But he could understand that enjoyment was important - in economists' speak, a 'utility' - and therefore should be factored into an improved version of the cap-m. That, he reckoned, is what study is for: you ask questions; find some answers; improve the models, or just improve the rules of thumb. Whichever, you make progress.
So when you next trade, think of Fischer Black and ask yourself: have I given enough thought to this move? Am I trading on noise or information? Do I have a clear idea of the reward I want for the risks I'm taking? Oh, and revise your thoughts about the capital-asset pricing model.
