Louis Bachelier

Louis Bachelier (1870-1946) was a French mathematician and the unsung father of modern financial theory. In his groundbreaking 1900 doctoral thesis, Théorie de la Spéculation (The Theory of Speculation), he pioneered the use of advanced mathematics to model financial markets. Bachelier proposed that the fluctuating prices of stocks could be described using the principles of what is now known as Brownian motion—a full five years before Albert Einstein famously used the same concept to explain the jittery movement of pollen particles in water. He developed a sophisticated mathematical framework for valuing stock options, laying the groundwork for many of the quantitative tools used today. His work was so far ahead of its time that it was largely ignored by the academic and financial communities for over half a century. It wasn't until the 1950s and 60s that his genius was rediscovered, posthumously establishing him as the originator of many concepts that underpin the Efficient Market Hypothesis (EMH) and the celebrated Black-Scholes model.

Bachelier's story is a classic tale of a visionary being too far ahead of his time. When he submitted his thesis to the prestigious Sorbonne in Paris, it was reviewed by the legendary mathematician Henri Poincaré. While Poincaré acknowledged the mathematical brilliance and originality of the work, he and the other committee members were skeptical of its application to the “messy” world of finance. The idea of subjecting market speculation to rigorous mathematical laws was simply too radical for the era. As a result, Bachelier was never granted a major university professorship and spent his career in relative academic obscurity. It took the work of influential economists like Paul Samuelson in the mid-20th century to dust off Bachelier's thesis and reveal its profound implications. They realized that this obscure French mathematician had, decades earlier, created the essential toolkit for the field we now call quantitative finance.

Bachelier's thesis introduced concepts that are now fundamental to our understanding of markets.

At the heart of Bachelier's work is the idea of the random walk. In simple terms, this theory states that future stock price movements are independent of past movements. The price of a stock tomorrow is essentially today's price plus a random, unpredictable 'step'. This implies that trying to predict short-term market movements by looking at past price charts (technical analysis) is a futile exercise. This concept is the direct ancestor of the weak form of the Efficient Market Hypothesis, which argues that all past price information is already reflected in the current stock price.

Bachelier was the first to successfully apply the mathematics of stochastic processes (processes that evolve randomly over time) to finance. This act single-handedly created the field of mathematical finance. His methods for pricing financial derivatives like options were revolutionary. While the later, more famous Black-Scholes model uses a slightly different mathematical assumption (geometric Brownian motion), its intellectual debt to Bachelier is immense. Every 'quant' on Wall Street today is, in a sense, standing on Bachelier's shoulders.

At first glance, Bachelier's ideas seem to be the antithesis of value investing. If markets are efficient and prices are random, how can one possibly find undervalued companies by studying their fundamentals? This is a crucial question, and the answer reveals a deeper harmony between these two perspectives.

The key is to understand what Bachelier's model describes. It brilliantly captures the short-term, second-by-second “noise” of the market—the chaotic flurry of trades driven by news, rumors, and mass psychology. This is what Warren Buffett famously called the “voting machine.” In this short-term arena, the market's movements do indeed appear random and unpredictable, just as Bachelier described. A value investor, however, is not playing this short-term game. They are focused on the long run, on what Buffett calls the “weighing machine.” A value investor believes that over time, a company's stock price will ultimately reflect its true underlying business value, or intrinsic value. They are not trying to predict the random 'steps' of the next day or week; they are patiently waiting for the 'weighing' process to occur over months or years.

For a value investor, Bachelier's work isn't a refutation of their strategy; it's a powerful explanation for why their strategy requires so much patience and discipline. It explains the erratic behavior of Mr. Market. Understanding that short-term price swings are often just random noise helps an investor ignore the daily chatter and avoid the panic-selling or greed-buying that destroys returns. In essence, Bachelier mathematically described the very market volatility that creates opportunities for the disciplined value investor. He showed us the 'votes', allowing the value investor to focus on the 'weight'.