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The Black-Litterman Model of Asset Allocation

Ashley Chorpenning

Businessman using a calculator to make investment decisions.

The Black-Litterman (BL) model is a mathematical technique for creating investment portfolios that maximize return for a given level of risk while also limiting the influence of human bias. It was developed in the 1990s to improve mean-variance optimization (MVO) or modern portfolio theory, a method that was created in the 1950s. This BL model aims to help portfolio managers or analysts spread risk among holdings while accounting for the investor’s market views. Here is an overview of the BL model and how it could help you create an investment portfolio that best matches your needs.

Black-Litterman Background

Although the creator of MVO won a Nobel Prize for his work, the method has two problems that professionals have struggled for decades to resolve. The first is that MVO portfolios often have highly concentrated asset allocations, in other words, are not genuinely diversified. That’s because if two asset classes have similar risk profiles but one has a slightly higher forecasted return, MVO allocates everything to the asset with the slightly stronger forecasted return and nothing to the other.

The second issue, which is related to the first, is that MVO portfolios change drastically as a portfolio manager’s forecasts for risk or return evolve in response to changes in the market.

How the BL Model Works

Mathematical equations on a blackboard

The BL model starts with a portfolio manager’s risk tolerance, which is expressed numerically, and opinion of a proposed portfolio’s return. The model then combines those two elements with the likely performance, or return, of a set of securities, typically stocks. The likely performance and risk are based on historical data.

Portfolio managers must first identify a consensus portfolio, such as a market index. This is the default portfolio that an investor would purchase in the absence of their opinion, special information, inclination or speculation on the market’s direction.  The BL model doesn’t depend on how portfolio managers selected their consensus portfolio.

The BL method also requires portfolio managers to predict the risk-free rate of return as well as the risk premium of the consensus portfolio. The risk premium rate will not ultimately impact the portfolio weights. However, it makes sure that the BL return estimate is  reasonable. On the other hand, the predicted risk-free rate of return is a vital input to the model. The model bases a return forecast on both components, which is referred to as the implied returns. Therefore, the implied returns result in a well-diversified portfolio that takes cues from the consensus portfolio.

When a portfolio manager changes the return predictions, the BL model doesn’t take these changes at face value. Instead, the model modifies returns that are consistent regarding how the changes will impact the asset classes and their correlation to each other. Essentially, the BL model identifies a compromise between all views of the portfolio manager.

The Bottom Line

Some ways of fixing MVO’s tendency to produce highly skewed and unstable portfolios is to impose constraints on the portfolio that the MVO can propose. The BL model, on the other hand, aims to fix the problem by qualifying the inputs from the portfolio manager. The upshot is a portfolio that is stable and well-diversified and that blends quantitative and qualitative approaches. It also shows portfolio managers how far their own views of a portfolio’s likely return and risk veer from those securities’ historical return and risk.

Investing Tips

  • The BL model is mathematically complex, so if you think it has a role to play in your portfolio, you should strongly consider working with a financial advisor. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • Consider capital gains taxes when you’re thinking about how much money you’ll make off your investments. SmartAsset’s capital gains tax calculator can help you figure out how taxes will impact the money you make from selling stocks.

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