Portfolio managers have different ways to create better portfolios. Some use an analytical tool called the “Black- Litterman” model to improve asset allocation within the risks an investor can tolerate and his market views. Hence, investors worldwide, like pension and insurance companies, should know where to delegate their investments to different asset classes and countries.
The BL model will start from a neutral position through the Modern Portfolio theory. From there, different investors’ views will contribute to how the ultimate asset allocation will deviate from the initial portfolio weight. Next, it will undergo mean-variance optimization or MVO to get more expected returns considering the risk one can tolerate.
The Modern Portfolio theory
We have mentioned the Modern Portfolio Theory, and it plays a significant role in the BL model. It is a theory that made Harry Markowitz a Nobel Prize winner in 1952. It states that an investor can maximize returns while taking the least possible risk. And they can lessen the risks if they use a quantitative method for diversification. MTP helps investors get more returns while taking minimal risks. Also, it assumes that all investors think the same way and they are all risk-averse. It stresses that risks are part of the process of getting a higher reward.
MTP says that looking at the investment’s risk and return characteristics is not enough. They should also evaluate how the investment affects the portfolio’s risk and return as a whole. Measures relative to statistics like variance and correlation state that an investment’s individual performance is less relative than its impact on the entire portfolio.
The BL model and the MPT
Now, let us know the connection between these two. Some people say that MPT is not perfect and that it has flaws and limitations. One of its limitations is its assumption that past expected returns are continuous. This is where the BL model enters the picture. It is created to improve on this model.
Other pricing models such as the Capital Asset Pricing Model or CAPM produce expectations that are not the same as the past performance. BL model combines these future expected returns projections that depend on models like CAPM and observes market data. This is what we mean earlier when we said that it starts with a neutral position through the MTP and incorporates the views of other investors. It is a modified MTP allocation that considers the expectations of future performance. Furthermore, the BL model does not discredit the estimation error for validity because allocation choices may translate into flawed assumptions.
Did you know?
The Black-Litterman model is named as such because it was created by two economists: Fischer Black and Robert Litterman. It has been receiving commendation from the institutional investment community since 1990 — the date of its creation. However, the model is not perfect, and it can still produce bias and incorrect assumptions. The projections are only opinions and results of pricing models that depend on subjective inputs. This can happen even when it is regarded as something that improves the asset allocations of MPT combined with the opinions of the future expectations.