What is the Black-Litterman Model?

The Black-Litterman model is a model used for an asset or portfolio allocation. This model was developed by two theorists at Goldman Sachs in 1990. The Black-Litterman model was named after Fischer Black and Robert Litterman, the theorists who developed it. The goal of the theory is to relieve the burden of institutional investors as it pertains to asset and portfolio allocation.

How Does the Black-Litterman Model Work?

The Black-Litterman model combines two core portfolio theories namely the capital asset pricing model (CAPM) and the modern portfolio theory. This model offers enormous benefits to institutional investors and portfolio managers by helping them adequately apply CAPM, optimization theory and modern portfolio theory in the practice of asset allocation. A Black-Litterman model is a mathematical approach to asset allocation that helps portfolio managers handle errors that might occur during allocation. This model also enhances the achievement of the expected portfolio returns within the concept of mean-variance optimization framework. The Black-Litterman model is in two versions which are the Black-Litterman (BL) model and the unconstrained Black-Litterman (UBL) model. While the former uses reverse optimization alongside investor's views on expected return as major factors in achieving a diversified market portfolio, the latter considers the weight asset weights as they reflect on investor's perspectives to determine the allocation of assets in a portfolio. The BL model aims to reduce the problem of return sensitivity in asset allocation. It also ensures that stable and efficient portfolios with adequate returns are achieved.