Black Litterman Model explained: theory and criticism
Black Litterman model: this article explains the Black Litterman model in a practical way. Next to what this theory is, this article also highlights Modern Portfolio Theory, Portfolio Management and criticism on the Black Litterman model. After reading it, you will understand the basics of this powerful financial management tool. Enjoy reading!
What is the Black Litterman model?
The Black-Litterman model is a mathematical tool for portfolio allocation. It is used by portfolio managers to manage and optimize asset allocation within the investor’s risk tolerances and market views. Investors worldwide must choose how to distribute their investments across different assets and countries. The BL model supports exactly this process.
The BL model was developed by Fischer Black and Robert Litterman in 1990, when they were working for Goldman Sachs. The model was published two years later. It seeks to solve the problems that have arisen for investors when applying Modern Portfolio Theory (MPT).
Applying the model starts with an asset allocation based on the equilibrium assumption. This assumption states that assets will perform in the future as they have in the past. This allocation is then adjusted by taking into account the investor’s view of the future performance of the assets.
- The BL model starts with Modern Portfolio Theory (MPT) and investor vision
- Historical market data is used to calculate future returns
- The investor adjusts the allocation of funds based on his own views
Modern Portfolio Theory (MPT)
The Black Litterman model is based on the Modern Portfolio Theory (MPT). It states that risk and return characteristics of different investments should not only be looked at, but should be assessed in terms of how the investment affects the risk and return of the entire portfolio.
MPT shows that an investor can build a portfolio of multiple asset types that maximizes returns for a given level of risk. An investor can therefore also put together a portfolio that has the least possible risk.
The Black Litterman model was developed to improve the MPT. One of its limitations is that MPT assumes that past returns will hold true in the future.
Pricing models such as the Capital Asset Pricing Model (CAPM) consider different expectations than past performance. The BL model contains market data that is assessed along with the projections of other models and investors.
The Black Litterman model is used in the context of portfolio management and portfolio optimization. Portfolio management is explained as the process of managing a client’s investments to maximize profits. In addition, the focus is on limiting risk, depending on the wishes of the client.
The entire process is aimed at making good decisions. Usually decisions are about:
- A profitable portolio mix
- Allocating assets per risk group
- Financial targets
- Diversifying assets
Criticism on the Black Litterman model
The BL model is believed to extend and improve the MPT by including opinions about future projections. But because these projections are just opinions or the result of subjective pricing models, the BL model can lead to biases.
An overly positive view of a class of assets can then lead to a greater weight of these assets in the portfolio, greater than the MPT would recommend. This could potentially lead to major losses. Investors using this model should take this into consideration.
Now it’s your turn
What do you think? Do you recognize the explanation about the BL model? Have you ever used this model in your work environment? What other financial tools do you know? Do you want to know more about the allocation of resources or related topics? Let us know in the comments.
Share your experience and knowledge in the comments box below.
- He, G., & Litterman, R. (2002). The intuition behind Black-Litterman model portfolios. Available at SSRN 334304.
- Idzorek, T. (2007). A step-by-step guide to the Black-Litterman model: Incorporating user-specified confidence levels. In Forecasting expected returns in the financial markets (pp. 17-38). Academic Press.
- Walters, C. F. A. (2014). The Black-Litterman model in detail. Available at SSRN 1314585.
How to cite this article:
Janse, B. (2023). Black Litterman Model explained: theory and criticism. Retrieved [insert date] from Toolshero: https://www.toolshero.com/financial-management/black-litterman-model/
Published on: 01/28/2023 | Last update: 03/04/2023
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