The Limits of Black–Scholes Framework
In this blog, I provide a brief introduction to the famous Black–Scholes partial differential equation and examine it from Charlie Munger's critical perspective. While the equation revolutionized option pricing and became a cornerstone of modern quantitative finance, its assumptions may limit its usefulness when applied to long-term stock investing. Before proceeding, I should note that I am not an expert in this field. The Black–Scholes framework begins with the assumption that a stock price follows a stochastic process, $dS=\mu Sdt+\sigma S dW$, where $S$ denotes the stock price, $\mu$ is the expected growth rate, $\sigma$ represents volatility, and $dW$ is Brownian motion. In essence, stock prices are modeled as evolving continuously through a combination of deterministic growth and random uncertainty. Using stochastic calculus, one arrives at $\frac{\partial V}{\partial t}+\frac{1}{2}\sigma^2S^2\frac{\partial^2V}{\partial S^2}+rS\frac{\partial V}{\partial S}-rV=0,$ where $V$ i...