However, Black suggested that risk should be spread out over an investor's lifetime, rather than being reserved only for youth.
He suggested that the dollar amount spent on risky investments should be a function of a leverage parameter, which remains constant over a person's lifetime, b, and the amount of investment in a safe asset w. Multiplying b and w gives you the amount a person should invest in riskier assets over their lifetime.
His assumptions on lifetime risk tolerance lead to the formation of Wells Fargo's Stagecoach Fund, a constantly leveraged fund.
Black claims to have found the solution to option pricing in June 1969. Despite his brilliance however, Black did not yet recognize what he found when he figured it out.
Departing from conventional logic, Black began by assuming that an option's price was only a function of the underlying stock's price x, and time, t. Using CAPM, and adding variables to account for systematic and unsystematic risk, Black came to the following equation:
w₂=rw-rxw₁-½v²x²w₁₁
This equation, though Black did not realize it at the time, was the secret to option pricing.
A for Bubba.
ReplyDeleteThis advice drives me crazy. Just about everyone I know takes the advice of people with a BA or MBA in finance, and declines the advice of those with a Ph.D. in those fields. That advice is to have more risk when old than investors usually do. One of the reasons for this is that more risk leads to more returns — and a lot of people live long enough to need those extra returns. The big risk for people planning their retirement is not risk but not saving enough in the first place; almost no one has trouble retiring because they were too heavily invested in stocks. Alternatively, it is relatively common to find older retirees running short of wealth because they haven't been aggressive enough.
Extra credit for Bubba (only) if he can tell me what he thought would be added to this post by including math that he can't explain. ;)