The Physics of Wall Street: a brief History of Predicting the Unpredictable

Physics Hits the Street 
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he was drawn to: it was (in his words) an equilibrium theory. “equi-
librium was the concept that attracted me to finance and econom-
ics,” Black wrote in 1987. cAPM was an equilibrium theory because 
it described economic value as the natural balance between risk and 
reward. the idea that the world was in a constantly evolving equi-
librium would have appealed to Black’s sensibilities as a physicist: in 
physics, one often finds that complicated systems tend toward states 
that are stable under small changes. these states are called equilibrium 
states because they, too, represent a kind of balance between different 
influences.
Black set out to learn everything that treynor knew about finance, 
so that when treynor left AdL, just a year after he and Black first met, 
Black was the natural person to take treynor’s place on AdL’s financial 
consulting team — and further perfect treynor’s model. cAPM would 
form the foundation for virtually all of the work Black would go on to 
do.
If Jack treynor initiated Black’s transformation into a financial econo-
mist, Myron Scholes brought it to fruition. Scholes arrived in cam-
bridge in September 1968, a fresh doctorate from the University of 
chicago in hand. A fellow graduate student in chicago, Michael Jen-
sen, had recommended that Scholes look up Black — an “interesting 
fellow,” in Jensen’s estimation. Scholes called soon after arriving in 
cambridge. Both men were young: Scholes had just turned twenty-
seven, and Black was thirty. neither was particularly accomplished, 
though Scholes’s recent appointment as an assistant professor at MIt 
was a promising sign. they met over lunch in the drab, institutional 
cafeteria at AdL’s Acorn Park campus. one rarely imagines history 
unfolding over a cafeteria meal shared by undistinguished men. And 
yet, that first meeting between Black and Scholes was the start of a 
friendship that would change financial markets forever.
Black and Scholes were polar opposites. Black was quiet, even shy. 
Scholes was outgoing and brash. Black was interested in applied work, 
but he had a theoretical, abstract mind. Scholes, meanwhile, had just 
written a heavily empirical thesis, analyzing piles of data to test the 
efficient market hypothesis, which by this point had been elevated to 

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a central principle of neoclassical economics. It is difficult to imag-
ine how that first conversation could have gone. And yet, something 
clearly clicked. the two men met again, and then again. Soon they had 
laid the foundation for a lifelong friendship and intellectual partner-
ship. Scholes invited Black to participate in the weekly MIt finance 
workshop, which was Black’s first opportunity to fully engage with fi-
nance academics. Soon after, Wells fargo approached Scholes with an 
offer for a consulting arrangement, to help the bank implement some 
of the new ideas in finance, like cAPM, that were just bubbling to the 
surface in academia. Scholes felt that he didn’t have enough time to 
do the work himself, but he knew someone who would be perfect for 
the job. Black quickly agreed, and in March 1969, some six months 
after that first meeting in the AdL cantina, Black quit his job at AdL 
and went off on his own. He started a new consulting firm, called As-
sociates in finance, with Wells fargo as his principal client. He and 
Scholes were tapped to help Wells fargo create a new, state-of-the-art 
investment strategy.
It was around this time that Black began thinking about ways to 
extend cAPM to different kinds of assets and different kinds of port-
folios. for instance, he tried to apply cAPM to the question of how to 
apportion one’s investments over time. Should you change your risk 
exposure as you get older, as some people were suggesting? Black de-
cided the answer was no: just as you want to diversify over different 
stocks at a given time, you also want to diversify over different times, 
to minimize the impact that any particular stretch of bad luck might 
have. the question of how to value options using cAPM was just one 
of the many such problems that Black was working on at this time. 
And as early as the summer of 1969, Black had already made progress, 
by deriving the fundamental relationship that would ultimately give 
rise to the Black-Scholes equation.
the essential insight was that at any given instant, it is always pos-
sible to create a portfolio consisting of a stock and an option on that 
stock that would be perfectly risk-free. If this sounds familiar, it’s be-
cause the idea is very similar to the one at the heart of thorp’s delta 
hedging strategy: he, too, realized that if the prices of options and their 
underlying assets are related, you could combine options and stocks 
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t h e p h y s i c s o f wa l l s t r e e t

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