Intuition Behind Black - Litterman Portfolio Selection

Investment
Management
Division
The Intuition Behind Black-Litterman
Model Portfolios
I In this article and as our title suggests, we demonstrate a method for
understanding the intuition behind the Black-Litterman asset allocation model.
I To do this, we use examples to show the difference between the traditional mean-
variance optimization process and the Black-Litterman process. We show that the
mean-variance optimization process, while academically sound, can produce
results that are extreme and not particularly intuitive. In contrast, we show that
the optimal portfolios generated by the Black-Litterman process have a simple,
intuitive property:
The unconstrained optimal portfolio is the market equilibrium portfolio
plus a weighted sum of portfolios representing an investors views.
The weight on a portfolio representing a view is positive when the
view is more bullish than the one implied by the equilibrium and
other views.
The weight increases as the investor becomes more bullish on the
view as well as when the investor becomes more confident about
the view.
December 1999
FRONTS
Goldman Sachs Investment Management
______________________________________________ 1 ____________________________________________
Investment Management Research The Intuition Behind Black-Litterman
Model Portfolios
Investment Management Research
Goldman Sachs Quantitative Resources Group
Guangliang He (212) 357-3210
Robert Litterman (212) 902-1677
Copyright 1999 Goldman, Sachs & Co. All rights reserved.
The information in this publication is for your private information and is not intended as an offer or solicitation to buy or sell any securities.
The information in this publication is for your private information and should not be construed as financial advice and it is not intended as an offer or
solicitation to buy or sell any securities. The sole purpose of this publication is to inform the reader about the intuition behind the Black-Litterman model
portfolios and is not intended as a solicitation for any Goldman Sachs product or service.
______________________________________________ 18 ____________________________________________
Model Portfolios
Appendix C
1. Given the expected returns and the covariance matrix , the unconstrained maximization problem
max
w
w w w 2 has a solution of ( ) w* =

1
.
2. Given the covariance matrix , the minimum variance portfolio is
( )
w
m ( )
=

1 1
, where is a vector
with all elements being one.
3. The solution to the risk constrained optimization problem, max w , subject to w w
2
, can be expressed
as * * *
) (
w w w w
r
= , where ( ) w* =

1
is the solution of the unconstrained problem.
4. The risk and budget constrained optimization problem can be formulated as max w , subject to w w
2
and = w 1. Its solution has the form w aw bw
b m ( ) ( )
* = + , where a and b are chosen in the way both risk
and budget constraints are satisfied.
5. The risk-, budget-, and beta-constrained optimization problem can be formulated as max w , subject to
w w
2
, = w 1, and = w w w w
eq eq eq
, where w
eq
is the market portfolio. The solution to the problem
has the form of w aw bw cw
m
eq
( ) ( )
*
= + + , where a , b , and c are chosen in the way all three constraints are
satisfied.
References
[1] Black, Fischer and Robert Litterman, Asset Allocation: Combining Investor Views With Market Equilibrium,
Goldman, Sachs & Co., Fixed Income Research, September 1990.
[2] Black, Fischer and Robert Litterman, Global Portfolio Optimization, Financial Analysts Journal, pages 28-
43, September-October 1992.
[3] Black, Fischer, Universal Hedging: Optimizing Currency Risk and Reward in International Equity
Portfolios, Financial Analysts Journal, pages 16-22, July-August 1989.
[4] Litterman, Robert, Hot Spots and Hedges, The Journal of Portfolio Management, pages 52-75, December
1996.
[5] Markowitz, Harry, Portfolio Selection, Journal of Finance, pages 77-91, March 1952.
BACKS
G o l d m a n S a c h s I n v e s t m e n t M a n a g e m e n t
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 5 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n v e s t m e n t M a n a g e m e n t R e s e a r c h T h e I n t u i t i o n B e h i n d B l a c k - L i t t e r m a n
M o d e l P o r t f o l i o s
C h a r t 1 C s h o w s t h e o p t i m a l p o r t f o l i o w e i g h t s c o m p u t e d b y s o l v i n g t h e
m e a n - v a r i a n c e p r o b l e m . U s i n g t h e e q u i l i b r i u m e x p e c t e d r e t u r n s , t h e
o p t i m a l p o r t f o l i o w e i g h t s a r e t h e m a r k e t p o r t f o l i o w e i g h t s . H o w e v e r , w h e n
t h e v i e w a b o u t G e r m a n y v e r s u s t h e r e s t o f E u r o p e i s i n c o r p o r a t e d , e v e n
t h o u g h t h e c h a n g e s o f t h e e x p e c t e d r e t u r n s f r o m t h e e q u i l i b r i u m e x p e c t e d
r e t u r n s a r e s m a l l a n d a r e l i m i t e d f o r E u r o p e a n c o u n t r i e s o n l y , t h e o p t i m a l
p o r t f o l i o i s q u i t e d i f f e r e n t f r o m w h a t o n e w o u l d h a v e e x p e c t e d : t h e
i n c r e a s e d w e i g h t i n t h e G e r m a n m a r k e t a n d t h e d e c r e a s e d w e i g h t s i n t h e
U n i t e d K i n g d o m a n d F r a n c e m a r k e t s a r e e x p e c t e d , b u t t h e r e d u c e d w e i g h t s
i n A u s t r a l i a a n d C a n a d a a n d t h e i n c r e a s e d w e i g h t s i n J a p a n a n d t h e
U n i t e d S t a t e s a r e v e r y p u z z l i n g . S i n c e t h e i n v e s t o r d o e s n o t h a v e a n y v i e w
o n t h e s e c o u n t r i e s , w h y s h o u l d s h e a d j u s t t h e w e i g h t i n t h e s e c o u n t r i e s ?
P r e s u m a b l y i t i s b e c a u s e o f t h e w a y t h e v i e w s a r e b e i n g t r a n s l a t e d i n t o
e x p e c t e d r e t u r n s . A s w e c a n s e e , t h e i n v e s t o r h a s a l r e a d y t r i e d t o t r a n s l a t e
t h e v i e w i n t o t h e e x p e c t e d r e t u r n s . C a n s h e p o s s i b l y d o b e t t e r ?
C h a r t 1 C . O p t i m a l P o r t f o l i o W e i g h t s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
S t a r t i n g f r o m E q u i l i b r i u m E x p e c t e d R e t u r n s
- 4 0 . 0 %
- 2 0 . 0 %
0 . 0 %
2 0 . 0 %
4 0 . 0 %
6 0 . 0 %
8 0 . 0 %
A U L C A N F R A G E R J A P U K G U S A
E q u i l i b r i u m W e i g h t s
E . R . S h i f t e d f o r E u r o p e a n C o u n t r i e s
T h i s c h a r t i s t o b e u s e d f o r i l l u s t r a t i v e p u r p o s e s o n l y .
T h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l a d d r e s s e s t h o s e p r a c t i c a l i s s u e s
i n u s i n g t h e M a r k o w i t z f r a m e w o r k b y a l l o w i n g t h e p o r t f o l i o m a n a g e r t o
e x p r e s s v i e w s a b o u t p o r t f o l i o s , r a t h e r t h a n a c o m p l e t e v e c t o r o f e x p e c t e d
r e t u r n s o n a l l a s s e t s . I n t h e s i m p l e s t o f c o n t e x t s w h e n t h e r e i s n o
b e n c h m a r k o r c o n s t r a i n t s t h e o p t i m a l p o r t f o l i o i s v e r y i n t u i t i v e . I t i s
s i m p l y a s e t o f d e v i a t i o n s f r o m m a r k e t c a p i t a l i z a t i o n w e i g h t s i n t h e
d i r e c t i o n s o f p o r t f o l i o s a b o u t w h i c h v i e w s a r e e x p r e s s e d . H e r e t h e B l a c k -
L i t t e r m a n m o d e l p r o v i d e s t h e a p p r o p r i a t e w e i g h t s o n t h e p o r t f o l i o s , b a s e d
o n s t a t e d e x p e c t e d r e t u r n s o n t h e p o r t f o l i o s a n d d e g r e e s o f c o n f i d e n c e i n
t h e s e v i e w s . T h e m o d e l b a l a n c e s t h e c o n t r i b u t i o n t o e x p e c t e d r e t u r n o f
e a c h o f t h e p o r t f o l i o s a b o u t w h i c h a v i e w i s e x p r e s s e d a g a i n s t i t s
c o n t r i b u t i o n t o o v e r a l l p o r t f o l i o r i s k . T h e s e r e s u l t s a r e t r a n s p a r e n t a n d
i n t u i t i v e .
D e t e r m i n i n g O p t i m a l
P o r t f o l i o W e i g h t s
T h e B l a c k - L i t t e r m a n A s s e t
A l l o c a t i o n M o d e l
______________________________________________ 2 ____________________________________________
Model Portfolios
Since publication in 1990, the Black-Litterman asset allocation model has
gained wide application in many financial institutions. As developed in the
original paper, the Black-Litterman model provides the flexibility to
combine the market equilibrium with additional market views of the
investor. In the Black-Litterman model, the user inputs any number of
views or statements about the expected returns of arbitrary portfolios, and
the model combines the views with equilibrium, producing both the set of
expected returns of assets as well as the optimal portfolio weights.
In contrast to the Black-Litterman model, in the traditional mean-variance
approach the user inputs a complete set of expected returns
1
, and the
portfolio optimizer generates the optimal portfolio weights. However,
users of the standard portfolio optimizers often find that their specification
of expected returns produces output portfolio weights which may not make
sense (due to the complex mapping between expected returns and portfolio
weights and the absence of a natural starting point for the expected return
assumptions).
In this article, we use examples to illustrate the difference between the
traditional mean-variance optimization process and the Black-Litterman
process. In so doing, we demonstrate how the Black-Litterman approach
2
provides both a reference point for expected return assumptions as well as a
systematic approach to deviating from this point to express ones market
views.
The Markowitz formulation of the portfolio optimization problem is a
brilliant quantification of the two basic objectives of investing: maximizing
expected return and minimizing risk. Having formed the foundation of
portfolio theory for the nearly half a century since its publication, this
framework has stood the test of time in the academic world. Unfortunately,
in the practical world of investment management, the Markowitz
framework has had surprisingly little impact. Why is that the case? We cite
two reasons.
First, investment managers tend to focus on small segments of their
potential investment universepicking stocks and other assets that they
feel are undervalued, finding assets with positive momentum, or identifying
relative value trades. Unfortunately, the Markowitz formulation
unrealistically requires expected returns to be specified for every
component of the relevant universe, which in practice is typically defined
by a broad benchmark.

1
Throughout this paper for simplicity we use the phrase expected return to refer to expected excess return over the one-period risk-
free rate.
2
The Black-Litterman model starts with equilibrium expected returns (as derived via the Capital Asset Pricing Model). This set of
expected returns is the neutral reference point of the Black-Litterman model.
Executive Summary
The Traditional Mean-
Variance Approach
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 4 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n s t e a d o f t r e a t i n g t h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l a s a b l a c k
b o x w h i c h g e n e r a t e s e x p e c t e d r e t u r n s i n s o m e m y s t e r i o u s w a y , w e h a v e
p r e s e n t e d a m e t h o d t o u n d e r s t a n d t h e i n t u i t i o n o f t h e m o d e l . W i t h t h e n e w
m e t h o d , i n v e s t i n g u s i n g t h e B l a c k - L i t t e r m a n m o d e l b e c o m e s v e r y i n t u i t i v e .
T h e i n v e s t o r s h o u l d i n v e s t i n t h e m a r k e t p o r t f o l i o f i r s t , t h e n d e v i a t e f r o m
m a r k e t w e i g h t s b y a d d i n g w e i g h t s o n p o r t f o l i o s r e p r e s e n t i n g h e r v i e w s .
T h e B l a c k - L i t t e r m a n m o d e l g i v e s t h e o p t i m a l w e i g h t s f o r t h e s e p o r t f o l i o s .
W h e n t h e i n v e s t o r h a s c o n s t r a i n t s , o r a d i f f e r e n t r i s k t o l e r a n c e l e v e l f r o m
t h e w o r l d a v e r a g e , s h e c a n a l w a y s u s e t h e e x p e c t e d r e t u r n s ( g e n e r a t e d b y
t h e B l a c k - L i t t e r m a n m o d e l a l o n g w i t h t h e c o v a r i a n c e m a t r i x ) i n a p o r t f o l i o
o p t i m i z a t i o n p a c k a g e t o o b t a i n t h e o p t i m a l p o r t f o l i o . U n l i k e a s t a n d a r d
m e a n - v a r i a n c e o p t i m i z a t i o n , t h e B l a c k - L i t t e r m a n m o d e l , i f p r o p e r l y
i m p l e m e n t e d , w i l l a l w a y s g e n e r a t e a n o p t i m a l p o r t f o l i o w h o s e w e i g h t s a r e
r e l a t i v e l y e a s y t o u n d e r s t a n d .
C o n c l u s i o n
______________________________________________ 17 ____________________________________________
Model Portfolios
Appendix B
1. There are N assets in the market. The market portfolio (equilibrium portfolio) is w
eq
. The covariance of
the returns is . The expected returns: is a vector of normally distributed random variables with
mean .
2. The average risk tolerance of the world is represented by the risk-aversion parameter . The equilibrium
expected returns are = w
eq
. The CAPM prior distribution for the expected returns is = +
( ) e
, where
( ) e
is normally distributed with mean zero and covariance . The parameter is a scalar measuring the
uncertainty of the CAPM prior.
3. The user has K views about the market, expressed as P Q
v
= +
( )
, where P is a K N matrix and Q is
K -vector, and
( ) v
is normally distributed with mean zero and covariance . The users views are
independent of the CAPM prior and independent of each other.
4. The mean of the expected returns is
( )
[ ]
( )
[ ] = + +

1 1
1
1 1
P P P Q .
5. The investor has the world average risk tolerance. The objective of the investor is to maximize the utility
w w w ' ' 2 . The unconstrained optimal portfolio is w
*
=

1
, which can be written as
w w P
eq
*
= + . Since the columns of matrix P are the portfolios in the users view, this means that the
unconstrained optimal portfolio is the market portfolio plus a weighted sum of the portfolios in the users
views. The weights for these portfolios are given by the elements of the vector , which is given by the
formula
[ ] [ ]
= + +

1
1 1
1
Q P P P w P P P P Q
eq
.
6. Let P , Q , and represent the K views held by the investor initially, be the expected returns by using
these views in the Black-Litterman model, be the weight vector defined above. Assume the investor now
has one additional view, represented by p , q , and . For the new case of K + 1 views, the new weight
vector is given by the following formula
( ) ( ) ( )
( ) ( ) ( )
'
'
q p A b c b A b
q p c b A b

1 1
1

where
A P P b P p c p p = + = = + , , . Since c b A b >
1
0 , the expression of shows the additional
view will have a positive (negative) weight if q p > 0 ( q p < 0 ), this corresponds to the case where
the new view on the portfolio p is more bullish (bearish) than implied by the old expected return . The
additional view will have a zero weight if q p = , this corresponds to the case where the new view is
implied by the old expected returns already. In this case, the new view has no impact at all.
7. For a particular viewk , its weight
k
is an increasing function of its expected return q
k
. The absolute
value of
k
is an increasing function of its confidence level
k
1
.
B
A
C
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______________________________________________ 3 ____________________________________________
Model Portfolios
Second, investment managers tend to think in terms of weights in a
portfolio rather than balancing expected returns against the contribution to
portfolio riskthe relevant margin in the Markowitz framework. When
managers try to optimize using the Markowitz approach, they usually find
that the portfolio weights returned by the optimizer (when not overly
constrained) tend to appear to be extreme and not particularly intuitive. In
practice most managers find that the effort required to specify expected
returns and constraints that lead to reasonable answers does not lead to a
commensurate benefit. Indeed this was the original motivation for Black
and Litterman to develop their approach.
The following example demonstrates the unstable behavior of the optimal
weights that can occur when using optimizers. In Chart 1A, we assume the
investor has only one view about the markets: German equity will
outperform European equities by 5% per year. Since our investor does not
have a complete set of expected returns for all markets, she starts by setting
the expected returns for all countries equal to 7 percent. To incorporate her
view, she then shifts the expected return for Germany up by 2.5% and
shifts the expected return for France and the United Kingdom down by
2.5 percent.
What this investor finds is that using equal means does not compensate for
the different levels of risk in assets of different countries and tends to
generate very extreme portfolios. Chart 1A shows that using the equal
expected returns as the starting point results in optimal weights of -33.5%
in Germany and 71.4% in Australia. A small shift in the expected returns
for the European equities (2.5% for Germany, -2.5% for France and the
United Kingdom) causes huge swings in the weights for these countries.
The weight for France now is -94.8 percent!
Chart 1A. Optimal Weights, Traditional Mean-Variance Approach
Starting from Equal Expected Returns
71.4%
-33.5%
-94.8%
-125.0%
-100.0%
-75.0%
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
100.0%
AUL CAN FRA GER JAP UKG USA
Equal Expected Returns
Expected Returns Shifted for European Countries
This chart is to be used for illustrative purposes only.
Unstable Behavior in
Portfolio Weights using
Optimizers
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
B l a c k a n d L i t t e r m a n a l s o d e m o n s t r a t e d t h e s h o r t c o m i n g s o f s e v e r a l o t h e r
m e t h o d s f o r s p e c i f y i n g a s t a r t i n g p o i n t f o r e x p e c t e d r e t u r n s . T h e y p o i n t e d
o u t t h a t a b e t t e r c h o i c e f o r t h e n e u t r a l e x p e c t e d r e t u r n s i s t o u s e t h e
e q u i l i b r i u m e x p e c t e d r e t u r n s a s d e v e l o p e d b y B l a c k . A m a j o r a d v a n t a g e o f
t h i s a p p r o a c h i s t h a t i t r e s u l t s i n m a r k e t c a p i t a l i z a t i o n p o r t f o l i o w e i g h t s
b e i n g o p t i m a l f o r a n i n v e s t o r u s i n g t h e m e a n - v a r i a n c e a p p r o a c h . N o w ,
a r m e d w i t h t h e e q u i l i b r i u m e x p e c t e d r e t u r n s
3
a s t h e n e u t r a l s t a r t i n g p o i n t ,
t h e i n v e s t o r t r a n s l a t e s h e r v i e w i n t o e x p e c t e d r e t u r n s .
T h e r e a r e m a n y d i f f e r e n t w a y s t o t r a n s l a t e t h e v i e w t o e x p e c t e d r e t u r n s .
F o r e x a m p l e , t h e i n v e s t o r c o u l d s i m p l y s h i f t t h e e x p e c t e d r e t u r n f o r
G e r m a n y t o b e 5 % h i g h e r t h a n t h e w e i g h t e d a v e r a g e e q u i l i b r i u m e x p e c t e d
r e t u r n s f o r t h e r e s t o f E u r o p e , b u t t h i s a p p r o a c h m a y s u g g e s t t h a t G e r m a n y
o u t p e r f o r m s t h e r e s t o f t h e w o r l d . T o b e p r e c i s e i n e x p r e s s i n g h e r v i e w ,
s h e s e t s t h e e x p e c t e d r e t u r n f o r G e r m a n y 5 % h i g h e r t h a n t h e ( m a r k e t
c a p i t a l i z a t i o n ) w e i g h t e d a v e r a g e o f t h e e x p e c t e d r e t u r n s o f F r a n c e a n d t h e
U n i t e d K i n g d o m . S h e s e t s t h e s u m o f m a r k e t c a p i t a l i z a t i o n - w e i g h t e d
e x p e c t e d r e t u r n s f o r t h e E u r o p e a n c o u n t r i e s a s u n c h a n g e d f r o m t h e
e q u i l i b r i u m v a l u e . S h e k e e p s t h e d i f f e r e n c e b e t w e e n t h e e x p e c t e d r e t u r n s
o f F r a n c e a n d t h e U n i t e d K i n g d o m u n c h a n g e d f r o m t h e e q u i l i b r i u m
d i f f e r e n c e i n v a l u e . C h a r t 1 B d e m o n s t r a t e s t h a t s i n c e t h e e q u i l i b r i u m
a l r e a d y i m p l i e s t h a t G e r m a n y w i l l o u t p e r f o r m t h e r e s t o f E u r o p e , t h e
c h a n g e i n t h e e x p e c t e d r e t u r n s i s a c t u a l l y q u i t e s m a l l .
C h a r t 1 B . E x p e c t e d R e t u r n s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
0
0 . 0 2
0 . 0 4
0 . 0 6
0 . 0 8
0 . 1
0 . 1 2
E q u i l i b r i u m E x p e c t e d R e t u r n s
0 . 6 %
1 . 7 %
0 . 4 %

3
T h r o u g h o u t o u r e x a m p l e s , w e u s e = 2 5. a s t h e r i s k a v e r s i o n p a r a m e t e r r e p r e s e n t i n g t h e w o r l d a v e r a g e r i s k t o l e r a n c e .
S p e c i f y i n g a S t a r t i n g P o i n t
f o r E x p e c t e d R e t u r n s
T r a n s l a t i n g V i e w s i n t o
E x p e c t e d R e t u r n s
______________________________________________ 16 ____________________________________________
Model Portfolios
Appendix A
Table 1: Annualized volatilities, market-capitalization weights, and equilibrium expected returns for the equity markets in
the seven countries.
Country
Equity Index
Volatility (%)
Equilibrium Portfolio
Weight (%)
Equilibrium Expected
Returns (%)
Australia 16.0 1.6 3.9
Canada 20.3 2.2 6.9
France 24.8 5.2 8.4
Germany 27.1 5.5 9.0
Japan 21.0 11.6 4.3
UK 20.0 12.4 6.8
USA 18.7 61.5 7.6
Table 2: Correlations among the equity index returns.
Australia Canada France Germany Japan UK
Canada 0.488
France 0.478 0.664
Germany 0.515 0.655 0.861
Japan 0.439 0.310 0.355 0.354
UK 0.512 0.608 0.783 0.777 0.405
USA 0.491 0.779 0.668 0.653 0.306 0.652
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 5 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
G e n e r a l
T h i s p r e s e n t a t i o n d o e s n o t c o n s t i t u t e a n o f f e r o r s o l i c i t a t i o n t o a n y p e r s o n i n a n y j u r i s d i c t i o n i n w h i c h s u c h o f f e r
o r s o l i c i t a t i o n i s n o t a u t h o r i z e d o r t o a n y p e r s o n t o w h o m i t w o u l d b e u n l a w f u l t o m a k e s u c h o f f e r o r
s o l i c i t a t i o n . I t i s t h e r e s p o n s i b i l i t y o f a n y p e r s o n o r p e r s o n s i n p o s s e s s i o n o f t h i s m a t e r i a l t o i n f o r m t h e m s e l v e s
o f a n d t o o b s e r v e a l l a p p l i c a b l e l a w s a n d r e g u l a t i o n s o f a n y r e l e v a n t j u r i s d i c t i o n . P r o s p e c t i v e i n v e s t o r s s h o u l d
i n f o r m t h e m s e l v e s a n d t a k e a p p r o p r i a t e a d v i c e a s t o a n y a p p l i c a b l e l e g a l r e q u i r e m e n t s a n d a n y a p p l i c a b l e
t a x a t i o n a n d e x c h a n g e c o n t r o l r e g u l a t i o n s i n t h e c o u n t r i e s o f t h e i r c i t i z e n s h i p , r e s i d e n c e o r d o m i c i l e w h i c h
m i g h t b e r e l e v a n t t o t h e s u b s c r i p t i o n , p u r c h a s e , h o l d i n g , e x c h a n g e , r e d e m p t i o n o r d i s p o s a l o f a n y i n v e s t m e n t s .
I n f o r m a t i o n c o n t a i n e d h e r e i n i s b e l i e v e d t o b e r e l i a b l e b u t n o w a r r a n t y i s g i v e n a s t o i t s c o m p l e t e n e s s o r
a c c u r a c y a n d v i e w s a n d o p i n i o n s , w h i l s t g i v e n i n g o o d f a i t h , a r e s u b j e c t t o c h a n g e w i t h o u t n o t i c e . M e m b e r s o f
t h e G o l d m a n S a c h s A s s e t M a n a g e m e n t g r o u p o f c o m p a n i e s a n d t h e i r a f f i l i a t e s , c o n n e c t e d p e r s o n s a n d
e m p l o y e e s m a y f r o m t i m e t o t i m e d e a l , h o l d o r a c t a s m a r k e t - m a k e r s , a d v i s e r s o r b r o k e r s i n r e l a t i o n t o a n y
i n v e s t m e n t s , o r d e r i v a t i v e s t h e r e o f , o r b e o t h e r w i s e i n t e r e s t e d t h e r e i n .
P a s t p e r f o r m a n c e i s n o t a g u i d e t o f u t u r e p e r f o r m a n c e a n d t h e v a l u e o f i n v e s t m e n t s a n d t h e i n c o m e d e r i v e d f r o m
t h e m c a n g o d o w n a s w e l l a s u p . F u t u r e r e t u r n s a r e n o t g u a r a n t e e d a n d a l o s s o f p r i n c i p a l m a y o c c u r . C h a n g e s
i n e x c h a n g e r a t e s m a y c a u s e t h e v a l u e o f a n i n v e s t m e n t t o i n c r e a s e o r d e c r e a s e . S o m e i n v e s t m e n t s m a y b e
r e s t r i c t e d o r i l l i q u i d , t h e r e m a y b e n o r e a d i l y a v a i l a b l e m a r k e t a n d t h e r e m a y b e d i f f i c u l t y i n o b t a i n i n g r e l i a b l e
i n f o r m a t i o n a b o u t t h e i r v a l u e a n d t h e e x t e n t o f t h e r i s k s t o w h i c h s u c h i n v e s t m e n t s a r e e x p o s e d . C e r t a i n
i n v e s t m e n t s , i n c l u d i n g w a r r a n t s a n d s i m i l a r s e c u r i t i e s , o f t e n i n v o l v e a h i g h d e g r e e o f g e a r i n g o r l e v e r a g e s o t h a t
a r e l a t i v e l y s m a l l m o v e m e n t i n p r i c e o f t h e u n d e r l y i n g s e c u r i t y o r b e n c h m a r k m a y r e s u l t i n a d i s p r o p o r t i o n a t e l y
l a r g e m o v e m e n t , u n f a v o u r a b l e a s w e l l a s f a v o u r a b l e , i n t h e p r i c e o f t h e w a r r a n t o r s i m i l a r s e c u r i t y . I n a d d i t i o n ,
c e r t a i n i n v e s t m e n t s , i n c l u d i n g f u t u r e s , s w a p s , f o r w a r d s , c e r t a i n o p t i o n s a n d d e r i v a t i v e s , w h e t h e r o n o r o f f
e x c h a n g e , m a y i n v o l v e c o n t i n g e n t l i a b i l i t y r e s u l t i n g i n a n e e d f o r t h e i n v e s t o r t o p a y m o r e t h a n t h e a m o u n t
o r i g i n a l l y i n v e s t e d a n d m a y p o s s i b l y r e s u l t i n u n q u a n t i f i a b l e f u r t h e r l o s s e x c e e d i n g t h e a m o u n t i n v e s t e d .
T r a n s a c t i o n s i n o v e r - t h e - c o u n t e r d e r i v a t i v e s i n v o l v e a d d i t i o n a l r i s k s a s t h e r e i s n o m a r k e t o n w h i c h t o c l o s e o u t
a n o p e n p o s i t i o n ; i t m a y b e i m p o s s i b l e t o l i q u i d a t e a n e x i s t i n g p o s i t i o n , t o a s s e s s t h e v a l u e o f a p o s i t i o n o r t o
a s s e s s t h e e x p o s u r e t o r i s k . I n v e s t o r s s h o u l d c a r e f u l l y c o n s i d e r w h e t h e r s u c h i n v e s t m e n t s a r e s u i t a b l e f o r t h e m
i n l i g h t o f t h e i r e x p e r i e n c e , c i r c u m s t a n c e s a n d f i n a n c i a l r e s o u r c e s .
O p i n i o n s e x p r e s s e d a r e c u r r e n t o p i n i o n s a s o f t h e d a t e a p p e a r i n g i n t h i s m a t e r i a l o n l y . N o p a r t o f t h i s m a t e r i a l
m a y b e i ) c o p i e d , p h o t o c o p i e d o r d u p l i c a t e d i n a n y f o r m , b y a n y m e a n s , o r i i ) r e d i s t r i b u t e d w i t h o u t G o l d m a n
S a c h s A s s e t M a n a g e m e n t ' s p r i o r w r i t t e n c o n s e n t .
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
S e c o n d , i n v e s t m e n t m a n a g e r s t e n d t o t h i n k i n t e r m s o f w e i g h t s i n a
p o r t f o l i o r a t h e r t h a n b a l a n c i n g e x p e c t e d r e t u r n s a g a i n s t t h e c o n t r i b u t i o n t o
p o r t f o l i o r i s k t h e r e l e v a n t m a r g i n i n t h e M a r k o w i t z f r a m e w o r k . W h e n
m a n a g e r s t r y t o o p t i m i z e u s i n g t h e M a r k o w i t z a p p r o a c h , t h e y u s u a l l y f i n d
t h a t t h e p o r t f o l i o w e i g h t s r e t u r n e d b y t h e o p t i m i z e r ( w h e n n o t o v e r l y
c o n s t r a i n e d ) t e n d t o a p p e a r t o b e e x t r e m e a n d n o t p a r t i c u l a r l y i n t u i t i v e . I n
p r a c t i c e m o s t m a n a g e r s f i n d t h a t t h e e f f o r t r e q u i r e d t o s p e c i f y e x p e c t e d
r e t u r n s a n d c o n s t r a i n t s t h a t l e a d t o r e a s o n a b l e a n s w e r s d o e s n o t l e a d t o a
c o m m e n s u r a t e b e n e f i t . I n d e e d t h i s w a s t h e o r i g i n a l m o t i v a t i o n f o r B l a c k
a n d L i t t e r m a n t o d e v e l o p t h e i r a p p r o a c h .
T h e f o l l o w i n g e x a m p l e d e m o n s t r a t e s t h e u n s t a b l e b e h a v i o r o f t h e o p t i m a l
w e i g h t s t h a t c a n o c c u r w h e n u s i n g o p t i m i z e r s . I n C h a r t 1 A , w e a s s u m e t h e
i n v e s t o r h a s o n l y o n e v i e w a b o u t t h e m a r k e t s : G e r m a n e q u i t y w i l l
o u t p e r f o r m E u r o p e a n e q u i t i e s b y 5 % p e r y e a r . S i n c e o u r i n v e s t o r d o e s n o t
h a v e a c o m p l e t e s e t o f e x p e c t e d r e t u r n s f o r a l l m a r k e t s , s h e s t a r t s b y s e t t i n g
t h e e x p e c t e d r e t u r n s f o r a l l c o u n t r i e s e q u a l t o 7 p e r c e n t . T o i n c o r p o r a t e h e r
v i e w , s h e t h e n s h i f t s t h e e x p e c t e d r e t u r n f o r G e r m a n y u p b y 2 . 5 % a n d
s h i f t s t h e e x p e c t e d r e t u r n f o r F r a n c e a n d t h e U n i t e d K i n g d o m d o w n b y
2 . 5 p e r c e n t .
W h a t t h i s i n v e s t o r f i n d s i s t h a t u s i n g e q u a l m e a n s d o e s n o t c o m p e n s a t e f o r
t h e d i f f e r e n t l e v e l s o f r i s k i n a s s e t s o f d i f f e r e n t c o u n t r i e s a n d t e n d s t o
g e n e r a t e v e r y e x t r e m e p o r t f o l i o s . C h a r t 1 A s h o w s t h a t u s i n g t h e e q u a l
e x p e c t e d r e t u r n s a s t h e s t a r t i n g p o i n t r e s u l t s i n o p t i m a l w e i g h t s o f - 3 3 . 5 %
i n G e r m a n y a n d 7 1 . 4 % i n A u s t r a l i a . A s m a l l s h i f t i n t h e e x p e c t e d r e t u r n s
f o r t h e E u r o p e a n e q u i t i e s ( 2 . 5 % f o r G e r m a n y , - 2 . 5 % f o r F r a n c e a n d t h e
U n i t e d K i n g d o m ) c a u s e s h u g e s w i n g s i n t h e w e i g h t s f o r t h e s e c o u n t r i e s .
T h e w e i g h t f o r F r a n c e n o w i s - 9 4 . 8 p e r c e n t !
C h a r t 1 A . O p t i m a l W e i g h t s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
S t a r t i n g f r o m E q u a l E x p e c t e d R e t u r n s
7 1 . 4 %
- 3 3 . 5 %
- 9 4 . 8 %
- 1 2 5 . 0 %
- 1 0 0 . 0 %
- 7 5 . 0 %
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
1 0 0 . 0 %
E q u a l E x p e c t e d R e t u r n s
E x p e c t e d R e t u r n s S h i f t e d f o r E u r o p e a n C o u n t r i e s
U n s t a b l e B e h a v i o r i n
P o r t f o l i o W e i g h t s u s i n g
O p t i m i z e r s
______________________________________________ 4 ____________________________________________
Model Portfolios
Black and Litterman also demonstrated the shortcomings of several other
methods for specifying a starting point for expected returns. They pointed
out that a better choice for the neutral expected returns is to use the
equilibrium expected returns as developed by Black. A major advantage of
this approach is that it results in market capitalization portfolio weights
being optimal for an investor using the mean-variance approach. Now,
armed with the equilibrium expected returns
3
as the neutral starting point,
the investor translates her view into expected returns.
There are many different ways to translate the view to expected returns.
For example, the investor could simply shift the expected return for
Germany to be 5% higher than the weighted average equilibrium expected
returns for the rest of Europe, but this approach may suggest that Germany
outperforms the rest of the world. To be precise in expressing her view,
she sets the expected return for Germany 5% higher than the (market
capitalization) weighted average of the expected returns of France and the
United Kingdom. She sets the sum of market capitalization-weighted
expected returns for the European countries as unchanged from the
equilibrium value. She keeps the difference between the expected returns
of France and the United Kingdom unchanged from the equilibrium
difference in value. Chart 1B demonstrates that since the equilibrium
already implies that Germany will outperform the rest of Europe, the
change in the expected returns is actually quite small.
Chart 1B. Expected Returns, Traditional Mean-Variance Approach
Starting from Equilibrium Expected Returns
0
0.02
0.04
0.06
0.08
0.1
0.12
Equilibrium Expected Returns
E. R. Shifted for European Countries
0.6%
1.7%
0.4%

3
Throughout our examples, we use = 2 5 . as the risk aversion parameter representing the world average risk tolerance.
Specifying a Starting Point
for Expected Returns
Translating Views into
Expected Returns
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 6 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A p p e n d i x A
T a b l e 1 : A n n u a l i z e d v o l a t i l i t i e s , m a r k e t - c a p i t a l i z a t i o n w e i g h t s , a n d e q u i l i b r i u m e x p e c t e d r e t u r n s f o r t h e e q u i t y m a r k e t s i n
t h e s e v e n c o u n t r i e s .
C o u n t r y
E q u i t y I n d e x
V o l a t i l i t y ( % )
E q u i l i b r i u m P o r t f o l i o
W e i g h t ( % )
E q u i l i b r i u m E x p e c t e d
R e t u r n s ( % )
A u s t r a l i a 1 6 . 0 1 . 6 3 . 9
C a n a d a 2 0 . 3 2 . 2 6 . 9
F r a n c e 2 4 . 8 5 . 2 8 . 4
G e r m a n y 2 7 . 1 5 . 5 9 . 0
J a p a n 2 1 . 0 1 1 . 6 4 . 3
U K 2 0 . 0 1 2 . 4 6 . 8
U S A 1 8 . 7 6 1 . 5 7 . 6
T a b l e 2 : C o r r e l a t i o n s a m o n g t h e e q u i t y i n d e x r e t u r n s .
A u s t r a l i a C a n a d a F r a n c e G e r m a n y J a p a n U K
C a n a d a 0 . 4 8 8
F r a n c e 0 . 4 7 8 0 . 6 6 4
G e r m a n y 0 . 5 1 5 0 . 6 5 5 0 . 8 6 1
J a p a n 0 . 4 3 9 0 . 3 1 0 0 . 3 5 5 0 . 3 5 4
U K 0 . 5 1 2 0 . 6 0 8 0 . 7 8 3 0 . 7 7 7 0 . 4 0 5
U S A 0 . 4 9 1 0 . 7 7 9 0 . 6 6 8 0 . 6 5 3 0 . 3 0 6 0 . 6 5 2
______________________________________________ 15 ____________________________________________
Model Portfolios
General
This presentation does not constitute an offer or solicitation to any person in any jurisdiction in which such offer
or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or
solicitation. It is the responsibility of any person or persons in possession of this material to inform themselves
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Information contained herein is believed to be reliable but no warranty is given as to its completeness or
accuracy and views and opinions, whilst given in good faith, are subject to change without notice. Members of
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employees may from time to time deal, hold or act as market-makers, advisers or brokers in relation to any
investments, or derivatives thereof, or be otherwise interested therein.
Past performance is not a guide to future performance and the value of investments and the income derived from
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______________________________________________ 5 ____________________________________________
Model Portfolios
Chart 1C shows the optimal portfolio weights computed by solving the
mean-variance problem. Using the equilibrium expected returns, the
optimal portfolio weights are the market portfolio weights. However, when
the view about Germany versus the rest of Europe is incorporated, even
though the changes of the expected returns from the equilibrium expected
returns are small and are limited for European countries only, the optimal
portfolio is quite different from what one would have expected: the
increased weight in the German market and the decreased weights in the
United Kingdom and France markets are expected, but the reduced weights
in Australia and Canada and the increased weights in Japan and the
United States are very puzzling. Since the investor does not have any view
on these countries, why should she adjust the weight in these countries?
Presumably it is because of the way the views are being translated into
expected returns. As we can see, the investor has already tried to translate
the view into the expected returns. Can she possibly do better?
Chart 1C. Optimal Portfolio Weights, Traditional Mean-Variance Approach
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
Equilibrium Weights
The Black-Litterman asset allocation model addresses those practical issues
in using the Markowitz framework by allowing the portfolio manager to
express views about portfolios, rather than a complete vector of expected
returns on all assets. In the simplest of contextswhen there is no
benchmark or constraintsthe optimal portfolio is very intuitive. It is
simply a set of deviations from market capitalization weights in the
directions of portfolios about which views are expressed. Here the Black-
Litterman model provides the appropriate weights on the portfolios, based
on stated expected returns on the portfolios and degrees of confidence in
these views. The model balances the contribution to expected return of
each of the portfolios about which a view is expressed against its
contribution to overall portfolio risk. These results are transparent and
intuitive.
Determining Optimal
Portfolio Weights
The Black-Litterman Asset
Allocation Model
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 2 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
S i n c e p u b l i c a t i o n i n 1 9 9 0 , t h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l h a s
g a i n e d w i d e a p p l i c a t i o n i n m a n y f i n a n c i a l i n s t i t u t i o n s . A s d e v e l o p e d i n t h e
o r i g i n a l p a p e r , t h e B l a c k - L i t t e r m a n m o d e l p r o v i d e s t h e f l e x i b i l i t y t o
c o m b i n e t h e m a r k e t e q u i l i b r i u m w i t h a d d i t i o n a l m a r k e t v i e w s o f t h e
i n v e s t o r . I n t h e B l a c k - L i t t e r m a n m o d e l , t h e u s e r i n p u t s a n y n u m b e r o f
v i e w s o r s t a t e m e n t s a b o u t t h e e x p e c t e d r e t u r n s o f a r b i t r a r y p o r t f o l i o s , a n d
t h e m o d e l c o m b i n e s t h e v i e w s w i t h e q u i l i b r i u m , p r o d u c i n g b o t h t h e s e t o f
e x p e c t e d r e t u r n s o f a s s e t s a s w e l l a s t h e o p t i m a l p o r t f o l i o w e i g h t s .
I n c o n t r a s t t o t h e B l a c k - L i t t e r m a n m o d e l , i n t h e t r a d i t i o n a l m e a n - v a r i a n c e
a p p r o a c h t h e u s e r i n p u t s a c o m p l e t e s e t o f e x p e c t e d r e t u r n s
1
, a n d t h e
p o r t f o l i o o p t i m i z e r g e n e r a t e s t h e o p t i m a l p o r t f o l i o w e i g h t s . H o w e v e r ,
u s e r s o f t h e s t a n d a r d p o r t f o l i o o p t i m i z e r s o f t e n f i n d t h a t t h e i r s p e c i f i c a t i o n
o f e x p e c t e d r e t u r n s p r o d u c e s o u t p u t p o r t f o l i o w e i g h t s w h i c h m a y n o t m a k e
s e n s e ( d u e t o t h e c o m p l e x m a p p i n g b e t w e e n e x p e c t e d r e t u r n s a n d p o r t f o l i o
w e i g h t s a n d t h e a b s e n c e o f a n a t u r a l s t a r t i n g p o i n t f o r t h e e x p e c t e d r e t u r n
a s s u m p t i o n s ) .
I n t h i s a r t i c l e , w e u s e e x a m p l e s t o i l l u s t r a t e t h e d i f f e r e n c e b e t w e e n t h e
t r a d i t i o n a l m e a n - v a r i a n c e o p t i m i z a t i o n p r o c e s s a n d t h e B l a c k - L i t t e r m a n
p r o c e s s . I n s o d o i n g , w e d e m o n s t r a t e h o w t h e B l a c k - L i t t e r m a n a p p r o a c h
2
p r o v i d e s b o t h a r e f e r e n c e p o i n t f o r e x p e c t e d r e t u r n a s s u m p t i o n s a s w e l l a s a
s y s t e m a t i c a p p r o a c h t o d e v i a t i n g f r o m t h i s p o i n t t o e x p r e s s o n e s m a r k e t
v i e w s .
T h e M a r k o w i t z f o r m u l a t i o n o f t h e p o r t f o l i o o p t i m i z a t i o n p r o b l e m i s a
b r i l l i a n t q u a n t i f i c a t i o n o f t h e t w o b a s i c o b j e c t i v e s o f i n v e s t i n g : m a x i m i z i n g
e x p e c t e d r e t u r n a n d m i n i m i z i n g r i s k . H a v i n g f o r m e d t h e f o u n d a t i o n o f
p o r t f o l i o t h e o r y f o r t h e n e a r l y h a l f a c e n t u r y s i n c e i t s p u b l i c a t i o n , t h i s
f r a m e w o r k h a s s t o o d t h e t e s t o f t i m e i n t h e a c a d e m i c w o r l d . U n f o r t u n a t e l y ,
i n t h e p r a c t i c a l w o r l d o f i n v e s t m e n t m a n a g e m e n t , t h e M a r k o w i t z
f r a m e w o r k h a s h a d s u r p r i s i n g l y l i t t l e i m p a c t . W h y i s t h a t t h e c a s e ? W e c i t e
t w o r e a s o n s .
F i r s t , i n v e s t m e n t m a n a g e r s t e n d t o f o c u s o n s m a l l s e g m e n t s o f t h e i r
p o t e n t i a l i n v e s t m e n t u n i v e r s e p i c k i n g s t o c k s a n d o t h e r a s s e t s t h a t t h e y
f e e l a r e u n d e r v a l u e d , f i n d i n g a s s e t s w i t h p o s i t i v e m o m e n t u m , o r i d e n t i f y i n g
r e l a t i v e v a l u e t r a d e s . U n f o r t u n a t e l y , t h e M a r k o w i t z f o r m u l a t i o n
u n r e a l i s t i c a l l y r e q u i r e s e x p e c t e d r e t u r n s t o b e s p e c i f i e d f o r e v e r y
c o m p o n e n t o f t h e r e l e v a n t u n i v e r s e , w h i c h i n p r a c t i c e i s t y p i c a l l y d e f i n e d
b y a b r o a d b e n c h m a r k .

1
T h r o u g h o u t t h i s p a p e r f o r s i m p l i c i t y w e u s e t h e p h r a s e e x p e c t e d r e t u r n t o r e f e r t o e x p e c t e d e x c e s s r e t u r n o v e r t h e o n e - p e r i o d r i s k -
f r e e r a t e .
2
T h e B l a c k - L i t t e r m a n m o d e l s t a r t s w i t h e q u i l i b r i u m e x p e c t e d r e t u r n s ( a s d e r i v e d v i a t h e C a p i t a l A s s e t P r i c i n g M o d e l ) . T h i s s e t o f
e x p e c t e d r e t u r n s i s t h e n e u t r a l r e f e r e n c e p o i n t o f t h e B l a c k - L i t t e r m a n m o d e l .
E x e c u t i v e S u m m a r y
T h e T r a d i t i o n a l M e a n -
V a r i a n c e A p p r o a c h
______________________________________________ 14 ____________________________________________
Model Portfolios
Instead of treating the Black-Litterman asset allocation model as a black
box which generates expected returns in some mysterious way, we have
presented a method to understand the intuition of the model. With the new
method, investing using the Black-Litterman model becomes very intuitive.
The investor should invest in the market portfolio first, then deviate from
market weights by adding weights on portfolios representing her views.
The Black-Litterman model gives the optimal weights for these portfolios.
When the investor has constraints, or a different risk tolerance level from
the world average, she can always use the expected returns (generated by
the Black-Litterman model along with the covariance matrix) in a portfolio
optimization package to obtain the optimal portfolio. Unlike a standard
mean-variance optimization, the Black-Litterman model, if properly
implemented, will always generate an optimal portfolio whose weights are
relatively easy to understand.
Conclusion
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A p p e n d i x B
1 . T h e r e a r e N a s s e t s i n t h e m a r k e t . T h e m a r k e t p o r t f o l i o ( e q u i l i b r i u m p o r t f o l i o ) i s w
e q
. T h e c o v a r i a n c e o f
t h e r e t u r n s i s . T h e e x p e c t e d r e t u r n s : i s a v e c t o r o f n o r m a l l y d i s t r i b u t e d r a n d o m v a r i a b l e s w i t h
m e a n .
2 . T h e a v e r a g e r i s k t o l e r a n c e o f t h e w o r l d i s r e p r e s e n t e d b y t h e r i s k - a v e r s i o n p a r a m e t e r . T h e e q u i l i b r i u m
e x p e c t e d r e t u r n s a r e = w
e q
. T h e C A P M p r i o r d i s t r i b u t i o n f o r t h e e x p e c t e d r e t u r n s i s = +
( )e
, w h e r e
( )e
i s n o r m a l l y d i s t r i b u t e d w i t h m e a n z e r o a n d c o v a r i a n c e . T h e p a r a m e t e r i s a s c a l a r m e a s u r i n g t h e
u n c e r t a i n t y o f t h e C A P M p r i o r .
3 . T h e u s e r h a s K v i e w s a b o u t t h e m a r k e t , e x p r e s s e d a s P Q
v
= +
( )
, w h e r e P i s a K N m a t r i x a n d Q i s
K - v e c t o r , a n d
( )v
i s n o r m a l l y d i s t r i b u t e d w i t h m e a n z e r o a n d c o v a r i a n c e . T h e u s e r s v i e w s a r e
i n d e p e n d e n t o f t h e C A P M p r i o r a n d i n d e p e n d e n t o f e a c h o t h e r .
4 . T h e m e a n o f t h e e x p e c t e d r e t u r n s i s
( )
[ ]
( )
[ ] = + +

1 1
1
1 1
P P P Q .
5 . T h e i n v e s t o r h a s t h e w o r l d a v e r a g e r i s k t o l e r a n c e . T h e o b j e c t i v e o f t h e i n v e s t o r i s t o m a x i m i z e t h e u t i l i t y
w w w' ' 2 . T h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o i s w
*
=
1
, w h i c h c a n b e w r i t t e n a s
w w P
e q
*
= + . S i n c e t h e c o l u m n s o f m a t r i x P a r e t h e p o r t f o l i o s i n t h e u s e r s v i e w , t h i s m e a n s t h a t t h e
u n c o n s t r a i n e d o p t i m a l p o r t f o l i o i s t h e m a r k e t p o r t f o l i o p l u s a w e i g h t e d s u m o f t h e p o r t f o l i o s i n t h e u s e r s
v i e w s . T h e w e i g h t s f o r t h e s e p o r t f o l i o s a r e g i v e n b y t h e e l e m e n t s o f t h e v e c t o r , w h i c h i s g i v e n b y t h e
f o r m u l a
[ ] [ ]
= + +

1
1 1
1
Q P P P w P P P P Q
e q
.
6 . L e t P , Q , a n d r e p r e s e n t t h e K v i e w s h e l d b y t h e i n v e s t o r i n i t i a l l y , b e t h e e x p e c t e d r e t u r n s b y u s i n g
t h e s e v i e w s i n t h e B l a c k - L i t t e r m a n m o d e l , b e t h e w e i g h t v e c t o r d e f i n e d a b o v e . A s s u m e t h e i n v e s t o r n o w
h a s o n e a d d i t i o n a l v i e w , r e p r e s e n t e d b y p , q , a n d . F o r t h e n e w c a s e o f K + 1 v i e w s , t h e n e w w e i g h t
v e c t o r i s g i v e n b y t h e f o l l o w i n g f o r m u l a
( ) ( )( )
( ) ( )( )
'
'
q p A b c b A b
q p c b A b

1 1
1

w h e r e
A P P b P p c p p= + = = + , , . S i n c e c b A b >
1
0 , t h e e x p r e s s i o n o f s h o w s t h e a d d i t i o n a l
v i e w w i l l h a v e a p o s i t i v e ( n e g a t i v e ) w e i g h t i f q p > 0 ( q p < 0 ) , t h i s c o r r e s p o n d s t o t h e c a s e w h e r e
t h e n e w v i e w o n t h e p o r t f o l i o p i s m o r e b u l l i s h ( b e a r i s h ) t h a n i m p l i e d b y t h e o l d e x p e c t e d r e t u r n . T h e
a d d i t i o n a l v i e w w i l l h a v e a z e r o w e i g h t i f q p= , t h i s c o r r e s p o n d s t o t h e c a s e w h e r e t h e n e w v i e w i s
i m p l i e d b y t h e o l d e x p e c t e d r e t u r n s a l r e a d y . I n t h i s c a s e , t h e n e w v i e w h a s n o i m p a c t a t a l l .
7 . F o r a p a r t i c u l a r v i e w k , i t s w e i g h t
k
i s a n i n c r e a s i n g f u n c t i o n o f i t s e x p e c t e d r e t u r n q
k
. T h e a b s o l u t e
v a l u e o f
k
i s a n i n c r e a s i n g f u n c t i o n o f i t s c o n f i d e n c e l e v e l
k
1
.
B
A
C
K

R
I
G
H
T
S
I
D
E
B
L
A
C
K
B
L
U
E
R
E
D
+
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+
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 9 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n C h a r t 3 A , i n a d d i t i o n t o t h e o r i g i n a l v i e w t h a t G e r m a n e q u i t y w i l l
o u t p e r f o r m t h e r e s t o f t h e E u r o p e a n m a r k e t s , t h e i n v e s t o r h a s a n o t h e r v i e w
t h a t t h e C a n a d i a n e q u i t y m a r k e t w i l l o u t p e r f o r m t h e U S e q u i t y m a r k e t b y
3 % p e r a n n u m . T h e d e v i a t i o n s o f o p t i m a l p o r t f o l i o w e i g h t s f r o m
e q u i l i b r i u m w e i g h t s s h o w a n o v e r w e i g h t i n G e r m a n y a n d u n d e r w e i g h t i n a
m a r k e t c a p i t a l i z a t i o n - w e i g h t e d p o r t f o l i o o f F r a n c e a n d t h e U n i t e d
K i n g d o m , w h i c h i s t h e d i r e c t r e s u l t o f t h e f i r s t v i e w . I t a l s o s h o w s a n
o v e r w e i g h t i n C a n a d a a n d u n d e r w e i g h t i n t h e U n i t e d S t a t e s , w h i c h i s t h e
d i r e c t r e s u l t o f t h e s e c o n d v i e w . T h e w e i g h t s a r e s h o w n i n C h a r t 3 B .
C h a r t 3 A . W e i g h t s o f P o r t f o l i o s i n t h e V i e w s a n d O p t i m a l D e v i a t i o n s
B l a c k - L i t t e r m a n M o d e l w i t h T w o V i e w s
- 1 5 0 . 0 %
- 1 0 0 . 0 %
- 5 0 . 0 %
0 . 0 %
5 0 . 0 %
1 0 0 . 0 %
1 5 0 . 0 %
G e r m a n y v e r s u s R e s t o f E u r o p e
C a n a d a v e r s u s t h e U n i t e d S t a t e s
O p t i m a l D e v i a t i o n s
C h a r t 3 B . P o r t f o l i o W e i g h t s , B l a c k - L i t t e r m a n M o d e l w i t h T w o V i e w s
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
E q u i l i b r i u m W i e g h t s
O p t i m a l P o r t f o l i o W e i g h t s
T w o M a r k e t V i e w s
______________________________________________ 6 ____________________________________________
Model Portfolios
The real power of the Black-Litterman model arises when there is a
benchmark, a risk or beta target, or other constraints. In these contexts, the
optimal weights are no longer obvious or intuitive. Nonetheless, the
manager can be confident that the same tradeoff of risk and returnwhich
leads to intuitive results that match the managers intended views in the
unconstrained caseremains operative when there are constraints.
The Black-Litterman model starts with equilibrium expected returns.
According to the Capital Asset Pricing Model (CAPM), prices will adjust
until the expected returns of all assets in equilibrium are such that if all
investors hold the same belief, the demand for these assets will exactly
equal the outstanding supply. This set of expected returns is the neutral
reference point of the Black-Litterman model. The investor then can
express her views about the markets.
In the Black-Litterman model, a view is a general statement about the
expected return for any portfolio.
4
These views are combined with the
market equilibrium expected returns.
5
In the case when the investor does
not have any views about the markets, the expected returns from the Black-
Litterman model match the equilibrium, and the unconstrained optimal
portfolio is the market equilibrium (capitalization weights) portfolio. In the
case when the investor has one or more views about the market, the Black-
Litterman approach combines the information from the equilibrium and
tilts the optimal portfolio away from the market portfolio in the direction of
the investors views.
The view that German equity will outperform the rest of Europe is now
precisely expressed as an expected return of 5% for the portfolio of a long
position in German equity and short positions of market capitalization
weights for the rest of the European markets. The Black-Litterman model
uses these inputs to generate a set of expected returns
6
.
In contrast to the traditional approach, the Black-Litterman model adjusts
all of the expected returns away from their starting values in a manner
consistent with the view being expressed. Because the view is expressed
on the portfolio of a long position in German equity and short positions in
the rest of the European markets, the expected return on this portfolio is
raised from the value implied by the equilibriumbut is still below the 5%
expressed in the view. This is quite natural because the view includes a
degree of uncertainty associated with it, and thus the Black-Litterman
model is averaging the view with the equilibrium.

4
Mathematically, a view is expressed as p q = + , where is the vector of the expected returns, p is the weights of the portfolio
representing the view, q is the expected return of the portfolio. The uncertainty of the view is represented by the presence of a
normally distributed random variable with variance being . The confidence level of the view is 1 .
5
See Appendix B for the formula used to compute the expected returns of the Black-Litterman model.
6
Except otherwise noted, throughout this article, the confidence level on a view is calibrated so that the ratio between the parameters
, (defined in footnote 3) and (defined in Appendix B, number 2) is equal to the variance of the portfolio in the view, p p .
There is no need to separately specify the value of since only the ratio enters the Black-Litterman expected returns formula.
Market Equilibrium:
Reference Point for the
Black-Litterman Model
Expected Returns: One
Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 0 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
T h e n e x t q u e s t i o n i s : h o w d o e s t h e w e i g h t o n a p o r t f o l i o c h a n g e w h e n t h e
v i e w c h a n g e s ? W h a t w i l l h a p p e n i f t h e i n v e s t o r s v i e w o n C a n a d a v e r s u s
t h e U n i t e d S t a t e s i s m o r e b u l l i s h ? F o r e x a m p l e , t h e e x p e c t e d r e t u r n o n t h e
p o r t f o l i o c h a n g e s f r o m 3 % t o 4 % , w h i l e e v e r y t h i n g e l s e s t a y s t h e s a m e .
I n p u t t i n g a l l t h e s e p a r a m e t e r s i n t o t h e B l a c k - L i t t e r m a n m o d e l , t h e w e i g h t
o n t h e C a n a d a v e r s u s t h e U n i t e d S t a t e s i n c r e a s e s . I n g e n e r a l , k e e p i n g
e v e r y t h i n g e l s e f i x e d , t h e w e i g h t o n a p o r t f o l i o i n c r e a s e s a s t h e e x p e c t e d
r e t u r n o f t h e v i e w i n c r e a s e s . T h i s p r o p e r t y i s q u i t e i n t u i t i v e , s i n c e i t i s
n a t u r a l f o r t h e i n v e s t o r t o i n v e s t m o r e i n t h e p o r t f o l i o w h e n s h e b e l i e v e s t h e
r e t u r n o n t h e p o r t f o l i o i s h i g h e r .
O n e o f t h e f e a t u r e s o f t h e B l a c k - L i t t e r m a n m o d e l i s t h a t t h e i n v e s t o r c a n
e x p r e s s d i f f e r e n t d e g r e e s o f c o n f i d e n c e a b o u t t h e v i e w s . W h a t w i l l h a p p e n
t o t h e w e i g h t o n a p o r t f o l i o w h e n t h e i n v e s t o r b e c o m e s l e s s c o n f i d e n t a b o u t
t h e v i e w o n t h e p o r t f o l i o ? S u p p o s e n o w t h e i n v e s t o r s t i l l b e l i e v e s G e r m a n y
w i l l o u t p e r f o r m t h e r e s t o f E u r o p e b y 5 % p e r a n n u m , b u t s h e h a s l e s s
c o n f i d e n c e i n t h e v i e w . S u p p o s e s h e i s o n l y h a l f a s c o n f i d e n t a s i n t h e
p r e v i o u s e x a m p l e . I n a d d i t i o n , w e a s s u m e t h e i n v e s t o r s v i e w o n t h e
p o r t f o l i o o f C a n a d a v e r s u s U S A i s u n c h a n g e d a t 4 % e x p e c t e d r e t u r n . T h e
m a g n i t u d e o f t h e w e i g h t o n t h e p o r t f o l i o o f G e r m a n y v e r s u s t h e r e s t o f
E u r o p e d e c r e a s e s , w h i c h i s a l s o v e r y i n t u i t i v e . I f t h e i n v e s t o r h a s l e s s
c o n f i d e n c e i n a v i e w , s h e w o u l d t a k e l e s s r i s k i n t h e v i e w , e v e r y t h i n g e l s e
r e m a i n i n g t h e s a m e . T h e s e e f f e c t s a r e i l l u s t r a t e d i n c h a r t 4 .
W h e n w i l l t h e w e i g h t o n a p o r t f o l i o b e p o s i t i v e , n e g a t i v e , o r z e r o ? I t t u r n s
o u t t h a t t h e s i g n o f t h e w e i g h t o n a p o r t f o l i o a l s o h a s a v e r y i n t u i t i v e
m e a n i n g . I f t h e e x p e c t e d r e t u r n o f t h e p o r t f o l i o i s i d e n t i c a l t o t h e e x p e c t e d
r e t u r n o n t h e s a m e p o r t f o l i o g e n e r a t e d b y t h e B l a c k - L i t t e r m a n m o d e l
w i t h o u t t h e v i e w , t h e v i e w h a s n o i m p a c t a t a l l . S i n c e w e a l r e a d y k n o w t h a t
t h e w e i g h t o n a p o r t f o l i o i s a n i n c r e a s i n g f u n c t i o n o f t h e s t r e n g t h o f t h e
v i e w , w e c a n d e d u c e t h a t t h e w e i g h t o n t h e p o r t f o l i o i s p o s i t i v e , i f a n d o n l y
i f , t h e v i e w i s m o r e b u l l i s h t h a n i m p l i e d b y u s i n g t h e B l a c k - L i t t e r m a n
m o d e l w i t h o u t t h i s p a r t i c u l a r v i e w .
C h a r t 4 . W e i g h t s o n P o r t f o l i o s i n t h e V i e w s
0
0 . 2
0 . 4
0 . 6
E x a m p l e 3 M o r e B u l l i s h o n C a n a d a / U S A L e s s C o n f i d e n t o n
G e r m a n y / E u r o p e
G e r m a n y v e r s u s t h e R e s t o f E u r o p e
C a n a d a v e r s u s t h e U n i t e d S t a t e s
C h a n g e o f M a r k e t V i e w
D e g r e e o f C o n f i d e n c e i n t h e
M a r k e t V i e w
______________________________________________ 13 ____________________________________________
Model Portfolios
Chart 7. Black-Litterman Model with Two Views
Risk, Budget, and Beta Constrained
-75.0%
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights
Constrained Optimal Weights
Deviations from Equilibrium
In the Quantitative Strategies group
8
at Goldman Sachs Asset Management,
we develop quantitative models and use these models to manage portfolios.
The Black-Litterman model is the central framework for our modeling
process. Our process starts with finding a set of views that are profitable.
For example, it is well known that portfolios based on certain value factors
and portfolios based on momentum factors are consistently profitable. We
forecast the expected returns on portfolios which incorporate these factors
and construct a set of views. The Black-Litterman model takes these views
and constructs a set of expected returns on each asset. Although we
manage many portfolios for many clients, using different benchmarks,
different targeted risk levels, and different constraints on the portfolios, the
same set of expected returns from the Black-Litterman model is used
throughout. Even though the final portfolios may look different due to the
differences in benchmarks, targeted risk levels and constraints, all portfolios
are constructed to be consistent with the same set of views, and all will
have exposures to the same set of historically profitable return-generating
factors.

8
This group is part of the Quantitative Resources Group and was formerly known as Quantitative Research.
The Practical Application of
the Black-Litterman Model
8
factors.
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______________________________________________ 7 ____________________________________________
Model Portfolios
From the graph of the expected returns in Chart 2A, it seems counter-
intuitive to see that the expected returns for both France and the United
Kingdom are raised. On the contrary, the view expressed does not say
France or the United Kingdom will go down, it only says that they will
under-perform Germany. Since both France and the United Kingdom are
positively correlated with the view portfolio and the view raises the
expected return of this portfolio, it is natural to see the expected returns on
France and the United Kingdom increase as well. The same intuition
applies to the other countries in Chart 2A.
Chart 2A. Expected Returns, Black-Litterman Model
One View on Germany versus Rest of Europe
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Black-Litterman E.R.
The optimal portfolio weights in Chart 2B are computed by solving the
maximization problem. Compared to the equilibrium weights, the optimal
portfolio increases the weight in Germany and decreases the weights in
both France and the United Kingdom. One can see that the deviations from
the equilibrium weights are proportional to the portfolio of long Germany
and short France and the United Kingdomexactly the portfolio
representing the investors view. This result is very intuitive. Since the
investor has a view about this portfolio, she simply invests in this portfolio,
on top of her neutral weights, the equilibrium weights.
Optimal Portfolio Weights:
One Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 8 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
C h a r t 2 B . O p t i m a l P o r t f o l i o W e i g h t s , B l a c k - L i t t e r m a n M o d e l
O n e V i e w o n G e r m a n y v e r s u s t h e R e s t o f E u r o p e
- 2 0 . 0 %
0 . 0 %
2 0 . 0 %
4 0 . 0 %
6 0 . 0 %
8 0 . 0 %
O p t i m a l P o r t f o l i o
I n C h a r t 2 C , o n e c a n s e e t h a t t h e d e v i a t i o n s o f t h e o p t i m a l p o r t f o l i o f r o m
t h e e q u i l i b r i u m w e i g h t s a r e e x a c t l y p r o p o r t i o n a l t o t h e p o r t f o l i o o f a l o n g
p o s i t i o n i n G e r m a n y a n d a s h o r t p o s i t i o n o f m a r k e t c a p i t a l i z a t i o n - w e i g h t e d
F r a n c e a n d t h e U n i t e d K i n g d o m . T h i s r e s u l t i s n o t c o i n c i d e n t a l , a s i t
i l l u s t r a t e s a v e r y i m p o r t a n t p r o p e r t y o f t h e B l a c k - L i t t e r m a n m o d e l . I n
g e n e r a l , t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o f r o m t h e B l a c k - L i t t e r m a n
m o d e l i s t h e m a r k e t e q u i l i b r i u m p o r t f o l i o p l u s a w e i g h t e d s u m o f t h e
p o r t f o l i o s a b o u t w h i c h t h e i n v e s t o r h a s v i e w s .
C h a r t 2 C . O p t i m a l D e v i a t i o n s f r o m E q u i l i b r i u m W e i g h t s
B l a c k - L i t t e r m a n M o d e l
O n e V i e w o n G e r m a n y v e r s u s R e s t o f E u r o p e
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
O p t i m a l D e v i a t i o n : O n e
M a r k e t V i e w
______________________________________________ 12 ____________________________________________
Model Portfolios
In many cases, in addition to the risk constraint, the investor faces a budget
constraint which forces the sum of the total portfolio weights to be one.
With this constraint, there is a special global minimum-variance portfolio
which minimizes the variance among all possible portfolios satisfying the
budget constraint. Under both the budget constraint and the risk constraint,
the optimal portfolio is a linear combination of the unconstrained optimal
portfolio and the global minimum variance portfolio. The parameters are
chosen in the way that the combination satisfies both the risk constraint and
the budget constraint (Chart 6).
Risk and Budget Constrained
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights
In the last example, a beta constraint is added to the budget and risk
constraints. A beta constraint forces the beta of the portfolio with respect to
the market portfolio to be one. It can be shown that the optimal portfolio
under all three constraintsrisk, budget, and betais a linear combination
of the unconstrained optimal portfolio, the minimum-variance portfolio, and
the market equilibrium portfolio. The parameters are adjusted in a way that
all three constraints are satisfied (Chart 7).
Budget Constraint
Beta Constraint
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A l l t h e s e e x a m p l e s d i s p l a y a v e r y i m p o r t a n t p r o p e r t y o f t h e B l a c k -
L i t t e r m a n m o d e l : a n u n c o n s t r a i n e d i n v e s t o r u s i n g t h e m o d e l w i l l i n v e s t f i r s t
i n t h e m a r k e t p o r t f o l i o , t h e n i n t h e p o r t f o l i o s r e p r e s e n t i n g t h e v i e w s . S h e
w i l l n e v e r d e v i a t e f r o m t h e m a r k e t c a p i t a l i z a t i o n - w e i g h t e d p o r t f o l i o o n t h e
a s s e t s a b o u t w h i c h s h e d o e s n o t h a v e v i e w s .
A r r i v i n g a t t h e o p t i m a l p o r t f o l i o i s s o m e w h a t m o r e c o m p l e x i n t h e p r e s e n c e
o f c o n s t r a i n t s . I n g e n e r a l , w h e n t h e r e a r e c o n s t r a i n t s , t h e e a s i e s t w a y t o
f i n d t h e o p t i m a l p o r t f o l i o i s t o u s e t h e B l a c k - L i t t e r m a n m o d e l t o g e n e r a t e
t h e e x p e c t e d r e t u r n s f o r t h e a s s e t s , a n d t h e n u s e a m e a n - v a r i a n c e o p t i m i z e r
t o s o l v e t h e c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m . I n t h e s e s i t u a t i o n s , t h e
i n t u i t i o n o f t h e B l a c k - L i t t e r m a n m o d e l i s m o r e d i f f i c u l t t o s e e . H o w e v e r ,
o n e c a n s e e t h e i n t u i t i o n i n s l i g h t l y m o d i f i e d f o r m s i n a f e w s p e c i a l
c o n s t r a i n e d c a s e s .
7
A g a i n , t h e p o r t f o l i o s a b o u t w h i c h t h e i n v e s t o r h a s
v i e w s p l a y a c r i t i c a l r o l e i n t h e o p t i m a l p o r t f o l i o c o n s t r u c t i o n , e v e n i n t h e
c o n s t r a i n e d c a s e .
I n t h e c a s e o f h a v i n g a r i s k c o n s t r a i n t , t h e i n v e s t o r s o b j e c t i v e o f s e l e c t i n g
t h e o p t i m a l p o r t f o l i o i s t o m a x i m i z e t h e e x p e c t e d r e t u r n w h i l e k e e p i n g t h e
v o l a t i l i t y o f t h e p o r t f o l i o u n d e r t h e g i v e n l e v e l . I n t h i s c a s e , t h e o p t i m a l
p o r t f o l i o c a n b e f o u n d b y s c a l i n g t h e s o l u t i o n o f t h e u n c o n s t r a i n e d
o p t i m i z a t i o n p r o b l e m t o t h e d e s i r e d r i s k l e v e l . I n C h a r t 3 A , t h e i n v e s t o r
h a s t w o v i e w s . I f t h e i n v e s t o r i s t a r g e t i n g a r i s k l e v e l o f 2 0 % p e r a n n u m ,
s h e c a n c a l c u l a t e t h e c o n s t r a i n e d o p t i m a l p o r t f o l i o w e i g h t s b y t a k i n g t h e
u n c o n s t r a i n e d o p t i m a l w e i g h t s , m u l t i p l y i n g i t b y t h e r a t i o o f t h e t a r g e t e d
r i s k l e v e l o f 2 0 % a n d t h e v o l a t i l i t y o f t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o .
H o w e v e r , b e c a u s e o f t h e s c a l i n g , t h e d e v i a t i o n f r o m t h e e q u i l i b r i u m i s n o
l o n g e r a w e i g h t e d s u m o f t h e G e r m a n y / E u r o p e p o r t f o l i o a n d t h e
C a n a d a / U S A p o r t f o l i o o n l y . I t h a s a d d i t i o n a l e x p o s u r e c o m i n g f r o m t h e
s c a l i n g o f t h e m a r k e t e q u i l i b r i u m p o r t f o l i o ( C h a r t 5 ) .
C h a r t 5 . B l a c k - L i t t e r m a n M o d e l w i t h T w o V i e w s , R i s k C o n s t r a i n e d
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
C o n s t r a i n e d O p t i m a l W e i g h t s
D e v i a t i o n s f r o m E q u i l i b r i u m

7
T h e s o l u t i o n s t o t h e u n c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m a s w e l l a s t o s e v e r a l s p e c i a l c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m s a r e g i v e n i n
A p p e n d i x C .
T h e C o n s t r a i n e d O p t i m a l
P o r t f o l i o
R i s k C o n s t r a i n t
B
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
F r o m t h e g r a p h o f t h e e x p e c t e d r e t u r n s i n C h a r t 2 A , i t s e e m s c o u n t e r -
i n t u i t i v e t o s e e t h a t t h e e x p e c t e d r e t u r n s f o r b o t h F r a n c e a n d t h e U n i t e d
K i n g d o m a r e r a i s e d . O n t h e c o n t r a r y , t h e v i e w e x p r e s s e d d o e s n o t s a y
F r a n c e o r t h e U n i t e d K i n g d o m w i l l g o d o w n , i t o n l y s a y s t h a t t h e y w i l l
u n d e r - p e r f o r m G e r m a n y . S i n c e b o t h F r a n c e a n d t h e U n i t e d K i n g d o m a r e
p o s i t i v e l y c o r r e l a t e d w i t h t h e v i e w p o r t f o l i o a n d t h e v i e w r a i s e s t h e
e x p e c t e d r e t u r n o f t h i s p o r t f o l i o , i t i s n a t u r a l t o s e e t h e e x p e c t e d r e t u r n s o n
F r a n c e a n d t h e U n i t e d K i n g d o m i n c r e a s e a s w e l l . T h e s a m e i n t u i t i o n
a p p l i e s t o t h e o t h e r c o u n t r i e s i n C h a r t 2 A .
C h a r t 2 A . E x p e c t e d R e t u r n s , B l a c k - L i t t e r m a n M o d e l
0 . 0 %
2 . 0 %
4 . 0 %
6 . 0 %
8 . 0 %
1 0 . 0 %
1 2 . 0 %
B l a c k - L i t t e r m a n E . R .
T h e o p t i m a l p o r t f o l i o w e i g h t s i n C h a r t 2 B a r e c o m p u t e d b y s o l v i n g t h e
m a x i m i z a t i o n p r o b l e m . C o m p a r e d t o t h e e q u i l i b r i u m w e i g h t s , t h e o p t i m a l
p o r t f o l i o i n c r e a s e s t h e w e i g h t i n G e r m a n y a n d d e c r e a s e s t h e w e i g h t s i n
b o t h F r a n c e a n d t h e U n i t e d K i n g d o m . O n e c a n s e e t h a t t h e d e v i a t i o n s f r o m
t h e e q u i l i b r i u m w e i g h t s a r e p r o p o r t i o n a l t o t h e p o r t f o l i o o f l o n g G e r m a n y
a n d s h o r t F r a n c e a n d t h e U n i t e d K i n g d o m e x a c t l y t h e p o r t f o l i o
r e p r e s e n t i n g t h e i n v e s t o r s v i e w . T h i s r e s u l t i s v e r y i n t u i t i v e . S i n c e t h e
i n v e s t o r h a s a v i e w a b o u t t h i s p o r t f o l i o , s h e s i m p l y i n v e s t s i n t h i s p o r t f o l i o ,
o n t o p o f h e r n e u t r a l w e i g h t s , t h e e q u i l i b r i u m w e i g h t s .
O p t i m a l P o r t f o l i o W e i g h t s :
O n e M a r k e t V i e w
______________________________________________ 8 ____________________________________________
Model Portfolios
Chart 2B. Optimal Portfolio Weights, Black-Litterman Model
One View on Germany versus the Rest of Europe
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
Equilibrium Weights
Optimal Portfolio
In Chart 2C, one can see that the deviations of the optimal portfolio from
the equilibrium weights are exactly proportional to the portfolio of a long
position in Germany and a short position of market capitalization-weighted
France and the United Kingdom. This result is not coincidental, as it
illustrates a very important property of the Black-Litterman model. In
general, the unconstrained optimal portfolio from the Black-Litterman
model is the market equilibrium portfolio plus a weighted sum of the
portfolios about which the investor has views.
Chart 2C. Optimal Deviations from Equilibrium Weights
-25.0%
0.0%
25.0%
50.0%
Optimal Deviation: One
Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 2 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n m a n y c a s e s , i n a d d i t i o n t o t h e r i s k c o n s t r a i n t , t h e i n v e s t o r f a c e s a b u d g e t
c o n s t r a i n t w h i c h f o r c e s t h e s u m o f t h e t o t a l p o r t f o l i o w e i g h t s t o b e o n e .
W i t h t h i s c o n s t r a i n t , t h e r e i s a s p e c i a l g l o b a l m i n i m u m - v a r i a n c e p o r t f o l i o
w h i c h m i n i m i z e s t h e v a r i a n c e a m o n g a l l p o s s i b l e p o r t f o l i o s s a t i s f y i n g t h e
b u d g e t c o n s t r a i n t . U n d e r b o t h t h e b u d g e t c o n s t r a i n t a n d t h e r i s k c o n s t r a i n t ,
t h e o p t i m a l p o r t f o l i o i s a l i n e a r c o m b i n a t i o n o f t h e u n c o n s t r a i n e d o p t i m a l
p o r t f o l i o a n d t h e g l o b a l m i n i m u m v a r i a n c e p o r t f o l i o . T h e p a r a m e t e r s a r e
c h o s e n i n t h e w a y t h a t t h e c o m b i n a t i o n s a t i s f i e s b o t h t h e r i s k c o n s t r a i n t a n d
t h e b u d g e t c o n s t r a i n t ( C h a r t 6 ) .
C h a r t 6 . B l a c k - L i t t e r m a n M o d e l w i t h T w o V i e w s
R i s k a n d B u d g e t C o n s t r a i n e d
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
I n t h e l a s t e x a m p l e , a b e t a c o n s t r a i n t i s a d d e d t o t h e b u d g e t a n d r i s k
c o n s t r a i n t s . A b e t a c o n s t r a i n t f o r c e s t h e b e t a o f t h e p o r t f o l i o w i t h r e s p e c t t o
t h e m a r k e t p o r t f o l i o t o b e o n e . I t c a n b e s h o w n t h a t t h e o p t i m a l p o r t f o l i o
u n d e r a l l t h r e e c o n s t r a i n t s r i s k , b u d g e t , a n d b e t a i s a l i n e a r c o m b i n a t i o n
o f t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o , t h e m i n i m u m - v a r i a n c e p o r t f o l i o , a n d
t h e m a r k e t e q u i l i b r i u m p o r t f o l i o . T h e p a r a m e t e r s a r e a d j u s t e d i n a w a y t h a t
a l l t h r e e c o n s t r a i n t s a r e s a t i s f i e d ( C h a r t 7 ) .
B u d g e t C o n s t r a i n t
B e t a C o n s t r a i n t
______________________________________________ 11 ____________________________________________
Model Portfolios
All these examples display a very important property of the Black-
Litterman model: an unconstrained investor using the model will invest first
in the market portfolio, then in the portfolios representing the views. She
will never deviate from the market capitalization-weighted portfolio on the
assets about which she does not have views.
Arriving at the optimal portfolio is somewhat more complex in the presence
of constraints. In general, when there are constraints, the easiest way to
find the optimal portfolio is to use the Black-Litterman model to generate
the expected returns for the assets, and then use a mean-variance optimizer
to solve the constrained optimization problem. In these situations, the
intuition of the Black-Litterman model is more difficult to see. However,
one can see the intuition in slightly modified forms in a few special
constrained cases.
7
Again, the portfolios about which the investor has
views play a critical role in the optimal portfolio construction, even in the
constrained case.
In the case of having a risk constraint, the investors objective of selecting
the optimal portfolio is to maximize the expected return while keeping the
volatility of the portfolio under the given level. In this case, the optimal
portfolio can be found by scaling the solution of the unconstrained
optimization problem to the desired risk level. In Chart 3A, the investor
has two views. If the investor is targeting a risk level of 20% per annum,
she can calculate the constrained optimal portfolio weights by taking the
unconstrained optimal weights, multiplying it by the ratio of the targeted
risk level of 20% and the volatility of the unconstrained optimal portfolio.
However, because of the scaling, the deviation from the equilibrium is no
longer a weighted sum of the Germany/Europe portfolio and the
Canada/USA portfolio only. It has additional exposure coming from the
scaling of the market equilibrium portfolio (Chart 5).
Chart 5. Black-Litterman Model with Two Views, Risk Constrained
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights

7
The solutions to the unconstrained optimization problem as well as to several special constrained optimization problems are given in
Appendix C.
The Constrained Optimal
Portfolio
Risk Constraint
B
A
C
K

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______________________________________________ 9 ____________________________________________
Model Portfolios
In Chart 3A, in addition to the original view that German equity will
outperform the rest of the European markets, the investor has another view
that the Canadian equity market will outperform the US equity market by
3% per annum. The deviations of optimal portfolio weights from
equilibrium weights show an overweight in Germany and underweight in a
market capitalization-weighted portfolio of France and the United
Kingdom, which is the direct result of the first view. It also shows an
overweight in Canada and underweight in the United States, which is the
direct result of the second view. The weights are shown in Chart 3B.
Chart 3A. Weights of Portfolios in the Views and Optimal Deviations
Black-Litterman Model with Two Views
-150.0%
-100.0%
-50.0%
0.0%
50.0%
100.0%
150.0%
Germany versus Rest of Europe
Canada versus the United States
Optimal Deviations
Chart 3B. Portfolio Weights, Black-Litterman Model with Two Views
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Wieghts
Optimal Portfolio Weights
Two Market Views
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
T h e r e a l p o w e r o f t h e B l a c k - L i t t e r m a n m o d e l a r i s e s w h e n t h e r e i s a
b e n c h m a r k , a r i s k o r b e t a t a r g e t , o r o t h e r c o n s t r a i n t s . I n t h e s e c o n t e x t s , t h e
o p t i m a l w e i g h t s a r e n o l o n g e r o b v i o u s o r i n t u i t i v e . N o n e t h e l e s s , t h e
m a n a g e r c a n b e c o n f i d e n t t h a t t h e s a m e t r a d e o f f o f r i s k a n d r e t u r n w h i c h
l e a d s t o i n t u i t i v e r e s u l t s t h a t m a t c h t h e m a n a g e r s i n t e n d e d v i e w s i n t h e
u n c o n s t r a i n e d c a s e r e m a i n s o p e r a t i v e w h e n t h e r e a r e c o n s t r a i n t s .
T h e B l a c k - L i t t e r m a n m o d e l s t a r t s w i t h e q u i l i b r i u m e x p e c t e d r e t u r n s .
A c c o r d i n g t o t h e C a p i t a l A s s e t P r i c i n g M o d e l ( C A P M ) , p r i c e s w i l l a d j u s t
u n t i l t h e e x p e c t e d r e t u r n s o f a l l a s s e t s i n e q u i l i b r i u m a r e s u c h t h a t i f a l l
i n v e s t o r s h o l d t h e s a m e b e l i e f , t h e d e m a n d f o r t h e s e a s s e t s w i l l e x a c t l y
e q u a l t h e o u t s t a n d i n g s u p p l y . T h i s s e t o f e x p e c t e d r e t u r n s i s t h e n e u t r a l
r e f e r e n c e p o i n t o f t h e B l a c k - L i t t e r m a n m o d e l . T h e i n v e s t o r t h e n c a n
e x p r e s s h e r v i e w s a b o u t t h e m a r k e t s .
I n t h e B l a c k - L i t t e r m a n m o d e l , a v i e w i s a g e n e r a l s t a t e m e n t a b o u t t h e
e x p e c t e d r e t u r n f o r a n y p o r t f o l i o .
4
T h e s e v i e w s a r e c o m b i n e d w i t h t h e
m a r k e t e q u i l i b r i u m e x p e c t e d r e t u r n s .
5
I n t h e c a s e w h e n t h e i n v e s t o r d o e s
n o t h a v e a n y v i e w s a b o u t t h e m a r k e t s , t h e e x p e c t e d r e t u r n s f r o m t h e B l a c k -
L i t t e r m a n m o d e l m a t c h t h e e q u i l i b r i u m , a n d t h e u n c o n s t r a i n e d o p t i m a l
p o r t f o l i o i s t h e m a r k e t e q u i l i b r i u m ( c a p i t a l i z a t i o n w e i g h t s ) p o r t f o l i o . I n t h e
c a s e w h e n t h e i n v e s t o r h a s o n e o r m o r e v i e w s a b o u t t h e m a r k e t , t h e B l a c k -
L i t t e r m a n a p p r o a c h c o m b i n e s t h e i n f o r m a t i o n f r o m t h e e q u i l i b r i u m a n d
t i l t s t h e o p t i m a l p o r t f o l i o a w a y f r o m t h e m a r k e t p o r t f o l i o i n t h e d i r e c t i o n o f
t h e i n v e s t o r s v i e w s .
T h e v i e w t h a t G e r m a n e q u i t y w i l l o u t p e r f o r m t h e r e s t o f E u r o p e i s n o w
p r e c i s e l y e x p r e s s e d a s a n e x p e c t e d r e t u r n o f 5 % f o r t h e p o r t f o l i o o f a l o n g
p o s i t i o n i n G e r m a n e q u i t y a n d s h o r t p o s i t i o n s o f m a r k e t c a p i t a l i z a t i o n
w e i g h t s f o r t h e r e s t o f t h e E u r o p e a n m a r k e t s . T h e B l a c k - L i t t e r m a n m o d e l
u s e s t h e s e i n p u t s t o g e n e r a t e a s e t o f e x p e c t e d r e t u r n s
6
.
I n c o n t r a s t t o t h e t r a d i t i o n a l a p p r o a c h , t h e B l a c k - L i t t e r m a n m o d e l a d j u s t s
a l l o f t h e e x p e c t e d r e t u r n s a w a y f r o m t h e i r s t a r t i n g v a l u e s i n a m a n n e r
c o n s i s t e n t w i t h t h e v i e w b e i n g e x p r e s s e d . B e c a u s e t h e v i e w i s e x p r e s s e d
o n t h e p o r t f o l i o o f a l o n g p o s i t i o n i n G e r m a n e q u i t y a n d s h o r t p o s i t i o n s i n
t h e r e s t o f t h e E u r o p e a n m a r k e t s , t h e e x p e c t e d r e t u r n o n t h i s p o r t f o l i o i s
r a i s e d f r o m t h e v a l u e i m p l i e d b y t h e e q u i l i b r i u m b u t i s s t i l l b e l o w t h e 5 %
e x p r e s s e d i n t h e v i e w . T h i s i s q u i t e n a t u r a l b e c a u s e t h e v i e w i n c l u d e s a
d e g r e e o f u n c e r t a i n t y a s s o c i a t e d w i t h i t , a n d t h u s t h e B l a c k - L i t t e r m a n
m o d e l i s a v e r a g i n g t h e v i e w w i t h t h e e q u i l i b r i u m .

4
M a t h e m a t i c a l l y , a v i e w i s e x p r e s s e d a s p q = + , w h e r e i s t h e v e c t o r o f t h e e x p e c t e d r e t u r n s , p i s t h e w e i g h t s o f t h e p o r t f o l i o
r e p r e s e n t i n g t h e v i e w , q i s t h e e x p e c t e d r e t u r n o f t h e p o r t f o l i o . T h e u n c e r t a i n t y o f t h e v i e w i s r e p r e s e n t e d b y t h e p r e s e n c e o f a
n o r m a l l y d i s t r i b u t e d r a n d o m v a r i a b l e w i t h v a r i a n c e b e i n g . T h e c o n f i d e n c e l e v e l o f t h e v i e w i s 1 .
5
S e e A p p e n d i x B f o r t h e f o r m u l a u s e d t o c o m p u t e t h e e x p e c t e d r e t u r n s o f t h e B l a c k - L i t t e r m a n m o d e l .
6
E x c e p t o t h e r w i s e n o t e d , t h r o u g h o u t t h i s a r t i c l e , t h e c o n f i d e n c e l e v e l o n a v i e w i s c a l i b r a t e d s o t h a t t h e r a t i o b e t w e e n t h e p a r a m e t e r s
, ( d e f i n e d i n f o o t n o t e 3 ) a n d ( d e f i n e d i n A p p e n d i x B , n u m b e r 2 ) i s e q u a l t o t h e v a r i a n c e o f t h e p o r t f o l i o i n t h e v i e w , p p .
T h e r e i s n o n e e d t o s e p a r a t e l y s p e c i f y t h e v a l u e o f s i n c e o n l y t h e r a t i o e n t e r s t h e B l a c k - L i t t e r m a n e x p e c t e d r e t u r n s f o r m u l a .
M a r k e t E q u i l i b r i u m :
R e f e r e n c e P o i n t f o r t h e
E x p e c t e d R e t u r n s : O n e
M a r k e t V i e w
______________________________________________ 10 ____________________________________________
Model Portfolios
The next question is: how does the weight on a portfolio change when the
view changes? What will happen if the investors view on Canada versus
the United States is more bullish? For example, the expected return on the
portfolio changes from 3% to 4%, while everything else stays the same.
Inputting all these parameters into the Black-Litterman model, the weight
on the Canada versus the United States increases. In general, keeping
everything else fixed, the weight on a portfolio increases as the expected
return of the view increases. This property is quite intuitive, since it is
natural for the investor to invest more in the portfolio when she believes the
return on the portfolio is higher.
One of the features of the Black-Litterman model is that the investor can
express different degrees of confidence about the views. What will happen
to the weight on a portfolio when the investor becomes less confident about
the view on the portfolio? Suppose now the investor still believes Germany
will outperform the rest of Europe by 5% per annum, but she has less
confidence in the view. Suppose she is only half as confident as in the
previous example. In addition, we assume the investors view on the
portfolio of Canada versus USA is unchanged at 4% expected return. The
magnitude of the weight on the portfolio of Germany versus the rest of
Europe decreases, which is also very intuitive. If the investor has less
confidence in a view, she would take less risk in the view, everything else
remaining the same. These effects are illustrated in chart 4.
When will the weight on a portfolio be positive, negative, or zero? It turns
out that the sign of the weight on a portfolio also has a very intuitive
meaning. If the expected return of the portfolio is identical to the expected
return on the same portfolio generated by the Black-Litterman model
without the view, the view has no impact at all. Since we already know that
the weight on a portfolio is an increasing function of the strength of the
view, we can deduce that the weight on the portfolio is positive, if and only
if, the view is more bullish than implied by using the Black-Litterman
model without this particular view.
Chart 4. Weights on Portfolios in the Views
0
0.2
0.4
0.6
Example 3 More Bullish on Canada/USA Less Confident on
Germany/Europe
Germany versus the Rest of Europe
Change of Market View
Degree of Confidence in the
Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
R i s k , B u d g e t , a n d B e t a C o n s t r a i n e d
- 7 5 . 0 %
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
I n t h e Q u a n t i t a t i v e S t r a t e g i e s g r o u p
8
a t G o l d m a n S a c h s A s s e t M a n a g e m e n t ,
w e d e v e l o p q u a n t i t a t i v e m o d e l s a n d u s e t h e s e m o d e l s t o m a n a g e p o r t f o l i o s .
T h e B l a c k - L i t t e r m a n m o d e l i s t h e c e n t r a l f r a m e w o r k f o r o u r m o d e l i n g
p r o c e s s . O u r p r o c e s s s t a r t s w i t h f i n d i n g a s e t o f v i e w s t h a t a r e p r o f i t a b l e .
F o r e x a m p l e , i t i s w e l l k n o w n t h a t p o r t f o l i o s b a s e d o n c e r t a i n v a l u e f a c t o r s
a n d p o r t f o l i o s b a s e d o n m o m e n t u m f a c t o r s a r e c o n s i s t e n t l y p r o f i t a b l e . W e
f o r e c a s t t h e e x p e c t e d r e t u r n s o n p o r t f o l i o s w h i c h i n c o r p o r a t e t h e s e f a c t o r s
a n d c o n s t r u c t a s e t o f v i e w s . T h e B l a c k - L i t t e r m a n m o d e l t a k e s t h e s e v i e w s
a n d c o n s t r u c t s a s e t o f e x p e c t e d r e t u r n s o n e a c h a s s e t . A l t h o u g h w e
m a n a g e m a n y p o r t f o l i o s f o r m a n y c l i e n t s , u s i n g d i f f e r e n t b e n c h m a r k s ,
d i f f e r e n t t a r g e t e d r i s k l e v e l s , a n d d i f f e r e n t c o n s t r a i n t s o n t h e p o r t f o l i o s , t h e
s a m e s e t o f e x p e c t e d r e t u r n s f r o m t h e B l a c k - L i t t e r m a n m o d e l i s u s e d
t h r o u g h o u t . E v e n t h o u g h t h e f i n a l p o r t f o l i o s m a y l o o k d i f f e r e n t d u e t o t h e
d i f f e r e n c e s i n b e n c h m a r k s , t a r g e t e d r i s k l e v e l s a n d c o n s t r a i n t s , a l l p o r t f o l i o s
a r e c o n s t r u c t e d t o b e c o n s i s t e n t w i t h t h e s a m e s e t o f v i e w s , a n d a l l w i l l
h a v e e x p o s u r e s t o t h e s a m e s e t o f h i s t o r i c a l l y p r o f i t a b l e r e t u r n - g e n e r a t i n g
f a c t o r s .

8
T h i s g r o u p i s p a r t o f t h e Q u a n t i t a t i v e R e s o u r c e s G r o u p a n d w a s f o r m e r l y k n o w n a s Q u a n t i t a t i v e R e s e a r c h .
T h e P r a c t i c a l A p p l i c a t i o n o f
t h e B l a c k - L i t t e r m a n M o d e l
8
f a c t o r s .
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______________________________________________ 9 ____________________________________________
Model Portfolios
In Chart 3A, in addition to the original view that German equity will
outperform the rest of the European markets, the investor has another view
that the Canadian equity market will outperform the US equity market by
3% per annum. The deviations of optimal portfolio weights from
equilibrium weights show an overweight in Germany and underweight in a
market capitalization-weighted portfolio of France and the United
Kingdom, which is the direct result of the first view. It also shows an
overweight in Canada and underweight in the United States, which is the
direct result of the second view. The weights are shown in Chart 3B.
Chart 3A. Weights of Portfolios in the Views and Optimal Deviations
Black-Litterman Model with Two Views
-150.0%
-100.0%
-50.0%
0.0%
50.0%
100.0%
150.0%
Germany versus Rest of Europe
Optimal Deviations
Chart 3B. Portfolio Weights, Black-Litterman Model with Two Views
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Wieghts
Optimal Portfolio Weights
Two Market Views
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 6 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
T h e r e a l p o w e r o f t h e B l a c k - L i t t e r m a n m o d e l a r i s e s w h e n t h e r e i s a
b e n c h m a r k , a r i s k o r b e t a t a r g e t , o r o t h e r c o n s t r a i n t s . I n t h e s e c o n t e x t s , t h e
o p t i m a l w e i g h t s a r e n o l o n g e r o b v i o u s o r i n t u i t i v e . N o n e t h e l e s s , t h e
m a n a g e r c a n b e c o n f i d e n t t h a t t h e s a m e t r a d e o f f o f r i s k a n d r e t u r n w h i c h
l e a d s t o i n t u i t i v e r e s u l t s t h a t m a t c h t h e m a n a g e r s i n t e n d e d v i e w s i n t h e
u n c o n s t r a i n e d c a s e r e m a i n s o p e r a t i v e w h e n t h e r e a r e c o n s t r a i n t s .
T h e B l a c k - L i t t e r m a n m o d e l s t a r t s w i t h e q u i l i b r i u m e x p e c t e d r e t u r n s .
A c c o r d i n g t o t h e C a p i t a l A s s e t P r i c i n g M o d e l ( C A P M ) , p r i c e s w i l l a d j u s t
u n t i l t h e e x p e c t e d r e t u r n s o f a l l a s s e t s i n e q u i l i b r i u m a r e s u c h t h a t i f a l l
i n v e s t o r s h o l d t h e s a m e b e l i e f , t h e d e m a n d f o r t h e s e a s s e t s w i l l e x a c t l y
e q u a l t h e o u t s t a n d i n g s u p p l y . T h i s s e t o f e x p e c t e d r e t u r n s i s t h e n e u t r a l
r e f e r e n c e p o i n t o f t h e B l a c k - L i t t e r m a n m o d e l . T h e i n v e s t o r t h e n c a n
e x p r e s s h e r v i e w s a b o u t t h e m a r k e t s .
I n t h e B l a c k - L i t t e r m a n m o d e l , a v i e w i s a g e n e r a l s t a t e m e n t a b o u t t h e
e x p e c t e d r e t u r n f o r a n y p o r t f o l i o .
4
T h e s e v i e w s a r e c o m b i n e d w i t h t h e
m a r k e t e q u i l i b r i u m e x p e c t e d r e t u r n s .
5
I n t h e c a s e w h e n t h e i n v e s t o r d o e s
n o t h a v e a n y v i e w s a b o u t t h e m a r k e t s , t h e e x p e c t e d r e t u r n s f r o m t h e B l a c k -
L i t t e r m a n m o d e l m a t c h t h e e q u i l i b r i u m , a n d t h e u n c o n s t r a i n e d o p t i m a l
p o r t f o l i o i s t h e m a r k e t e q u i l i b r i u m ( c a p i t a l i z a t i o n w e i g h t s ) p o r t f o l i o . I n t h e
c a s e w h e n t h e i n v e s t o r h a s o n e o r m o r e v i e w s a b o u t t h e m a r k e t , t h e B l a c k -
L i t t e r m a n a p p r o a c h c o m b i n e s t h e i n f o r m a t i o n f r o m t h e e q u i l i b r i u m a n d
t i l t s t h e o p t i m a l p o r t f o l i o a w a y f r o m t h e m a r k e t p o r t f o l i o i n t h e d i r e c t i o n o f
t h e i n v e s t o r s v i e w s .
T h e v i e w t h a t G e r m a n e q u i t y w i l l o u t p e r f o r m t h e r e s t o f E u r o p e i s n o w
p r e c i s e l y e x p r e s s e d a s a n e x p e c t e d r e t u r n o f 5 % f o r t h e p o r t f o l i o o f a l o n g
p o s i t i o n i n G e r m a n e q u i t y a n d s h o r t p o s i t i o n s o f m a r k e t c a p i t a l i z a t i o n
w e i g h t s f o r t h e r e s t o f t h e E u r o p e a n m a r k e t s . T h e B l a c k - L i t t e r m a n m o d e l
u s e s t h e s e i n p u t s t o g e n e r a t e a s e t o f e x p e c t e d r e t u r n s
6
.
I n c o n t r a s t t o t h e t r a d i t i o n a l a p p r o a c h , t h e B l a c k - L i t t e r m a n m o d e l a d j u s t s
a l l o f t h e e x p e c t e d r e t u r n s a w a y f r o m t h e i r s t a r t i n g v a l u e s i n a m a n n e r
c o n s i s t e n t w i t h t h e v i e w b e i n g e x p r e s s e d . B e c a u s e t h e v i e w i s e x p r e s s e d
o n t h e p o r t f o l i o o f a l o n g p o s i t i o n i n G e r m a n e q u i t y a n d s h o r t p o s i t i o n s i n
t h e r e s t o f t h e E u r o p e a n m a r k e t s , t h e e x p e c t e d r e t u r n o n t h i s p o r t f o l i o i s
r a i s e d f r o m t h e v a l u e i m p l i e d b y t h e e q u i l i b r i u m b u t i s s t i l l b e l o w t h e 5 %
e x p r e s s e d i n t h e v i e w . T h i s i s q u i t e n a t u r a l b e c a u s e t h e v i e w i n c l u d e s a
d e g r e e o f u n c e r t a i n t y a s s o c i a t e d w i t h i t , a n d t h u s t h e B l a c k - L i t t e r m a n
m o d e l i s a v e r a g i n g t h e v i e w w i t h t h e e q u i l i b r i u m .

4
M a t h e m a t i c a l l y , a v i e w i s e x p r e s s e d a s p q = + , w h e r e i s t h e v e c t o r o f t h e e x p e c t e d r e t u r n s , p i s t h e w e i g h t s o f t h e p o r t f o l i o
r e p r e s e n t i n g t h e v i e w , q i s t h e e x p e c t e d r e t u r n o f t h e p o r t f o l i o . T h e u n c e r t a i n t y o f t h e v i e w i s r e p r e s e n t e d b y t h e p r e s e n c e o f a
n o r m a l l y d i s t r i b u t e d r a n d o m v a r i a b l e w i t h v a r i a n c e b e i n g . T h e c o n f i d e n c e l e v e l o f t h e v i e w i s 1 .
5
S e e A p p e n d i x B f o r t h e f o r m u l a u s e d t o c o m p u t e t h e e x p e c t e d r e t u r n s o f t h e B l a c k - L i t t e r m a n m o d e l .
6
E x c e p t o t h e r w i s e n o t e d , t h r o u g h o u t t h i s a r t i c l e , t h e c o n f i d e n c e l e v e l o n a v i e w i s c a l i b r a t e d s o t h a t t h e r a t i o b e t w e e n t h e p a r a m e t e r s
, ( d e f i n e d i n f o o t n o t e 3 ) a n d ( d e f i n e d i n A p p e n d i x B , n u m b e r 2 ) i s e q u a l t o t h e v a r i a n c e o f t h e p o r t f o l i o i n t h e v i e w , p p .
T h e r e i s n o n e e d t o s e p a r a t e l y s p e c i f y t h e v a l u e o f s i n c e o n l y t h e r a t i o e n t e r s t h e B l a c k - L i t t e r m a n e x p e c t e d r e t u r n s f o r m u l a .
M a r k e t E q u i l i b r i u m :
R e f e r e n c e P o i n t f o r t h e
E x p e c t e d R e t u r n s : O n e
M a r k e t V i e w
______________________________________________ 10 ____________________________________________
Model Portfolios
The next question is: how does the weight on a portfolio change when the
view changes? What will happen if the investors view on Canada versus
the United States is more bullish? For example, the expected return on the
portfolio changes from 3% to 4%, while everything else stays the same.
Inputting all these parameters into the Black-Litterman model, the weight
on the Canada versus the United States increases. In general, keeping
everything else fixed, the weight on a portfolio increases as the expected
return of the view increases. This property is quite intuitive, since it is
natural for the investor to invest more in the portfolio when she believes the
return on the portfolio is higher.
One of the features of the Black-Litterman model is that the investor can
express different degrees of confidence about the views. What will happen
to the weight on a portfolio when the investor becomes less confident about
the view on the portfolio? Suppose now the investor still believes Germany
will outperform the rest of Europe by 5% per annum, but she has less
confidence in the view. Suppose she is only half as confident as in the
previous example. In addition, we assume the investors view on the
portfolio of Canada versus USA is unchanged at 4% expected return. The
magnitude of the weight on the portfolio of Germany versus the rest of
Europe decreases, which is also very intuitive. If the investor has less
confidence in a view, she would take less risk in the view, everything else
remaining the same. These effects are illustrated in chart 4.
When will the weight on a portfolio be positive, negative, or zero? It turns
out that the sign of the weight on a portfolio also has a very intuitive
meaning. If the expected return of the portfolio is identical to the expected
return on the same portfolio generated by the Black-Litterman model
without the view, the view has no impact at all. Since we already know that
the weight on a portfolio is an increasing function of the strength of the
view, we can deduce that the weight on the portfolio is positive, if and only
if, the view is more bullish than implied by using the Black-Litterman
model without this particular view.
Chart 4. Weights on Portfolios in the Views
0
0.2
0.4
0.6
Example 3 More Bullish on Canada/USA Less Confident on
Germany/Europe
Germany versus the Rest of Europe
Change of Market View
Degree of Confidence in the
Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
R i s k , B u d g e t , a n d B e t a C o n s t r a i n e d
- 7 5 . 0 %
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
8
f a c t o r s .

8
T h i s g r o u p i s p a r t o f t h e Q u a n t i t a t i v e R e s o u r c e s G r o u p a n d w a s f o r m e r l y k n o w n a s Q u a n t i t a t i v e R e s e a r c h .
8
f a c t o r s .
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 7 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
F r o m t h e g r a p h o f t h e e x p e c t e d r e t u r n s i n C h a r t 2 A , i t s e e m s c o u n t e r -
i n t u i t i v e t o s e e t h a t t h e e x p e c t e d r e t u r n s f o r b o t h F r a n c e a n d t h e U n i t e d
K i n g d o m a r e r a i s e d . O n t h e c o n t r a r y , t h e v i e w e x p r e s s e d d o e s n o t s a y
F r a n c e o r t h e U n i t e d K i n g d o m w i l l g o d o w n , i t o n l y s a y s t h a t t h e y w i l l
u n d e r - p e r f o r m G e r m a n y . S i n c e b o t h F r a n c e a n d t h e U n i t e d K i n g d o m a r e
p o s i t i v e l y c o r r e l a t e d w i t h t h e v i e w p o r t f o l i o a n d t h e v i e w r a i s e s t h e
e x p e c t e d r e t u r n o f t h i s p o r t f o l i o , i t i s n a t u r a l t o s e e t h e e x p e c t e d r e t u r n s o n
F r a n c e a n d t h e U n i t e d K i n g d o m i n c r e a s e a s w e l l . T h e s a m e i n t u i t i o n
a p p l i e s t o t h e o t h e r c o u n t r i e s i n C h a r t 2 A .
C h a r t 2 A . E x p e c t e d R e t u r n s , B l a c k - L i t t e r m a n M o d e l
0 . 0 %
2 . 0 %
4 . 0 %
6 . 0 %
8 . 0 %
1 0 . 0 %
1 2 . 0 %
B l a c k - L i t t e r m a n E . R .
T h e o p t i m a l p o r t f o l i o w e i g h t s i n C h a r t 2 B a r e c o m p u t e d b y s o l v i n g t h e
m a x i m i z a t i o n p r o b l e m . C o m p a r e d t o t h e e q u i l i b r i u m w e i g h t s , t h e o p t i m a l
p o r t f o l i o i n c r e a s e s t h e w e i g h t i n G e r m a n y a n d d e c r e a s e s t h e w e i g h t s i n
b o t h F r a n c e a n d t h e U n i t e d K i n g d o m . O n e c a n s e e t h a t t h e d e v i a t i o n s f r o m
t h e e q u i l i b r i u m w e i g h t s a r e p r o p o r t i o n a l t o t h e p o r t f o l i o o f l o n g G e r m a n y
a n d s h o r t F r a n c e a n d t h e U n i t e d K i n g d o m e x a c t l y t h e p o r t f o l i o
r e p r e s e n t i n g t h e i n v e s t o r s v i e w . T h i s r e s u l t i s v e r y i n t u i t i v e . S i n c e t h e
i n v e s t o r h a s a v i e w a b o u t t h i s p o r t f o l i o , s h e s i m p l y i n v e s t s i n t h i s p o r t f o l i o ,
o n t o p o f h e r n e u t r a l w e i g h t s , t h e e q u i l i b r i u m w e i g h t s .
O p t i m a l P o r t f o l i o W e i g h t s :
O n e M a r k e t V i e w
______________________________________________ 8 ____________________________________________
Model Portfolios
Chart 2B. Optimal Portfolio Weights, Black-Litterman Model
One View on Germany versus the Rest of Europe
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
Equilibrium Weights
Optimal Portfolio
In Chart 2C, one can see that the deviations of the optimal portfolio from
the equilibrium weights are exactly proportional to the portfolio of a long
position in Germany and a short position of market capitalization-weighted
France and the United Kingdom. This result is not coincidental, as it
illustrates a very important property of the Black-Litterman model. In
general, the unconstrained optimal portfolio from the Black-Litterman
model is the market equilibrium portfolio plus a weighted sum of the
portfolios about which the investor has views.
Chart 2C. Optimal Deviations from Equilibrium Weights
-25.0%
0.0%
25.0%
50.0%
Optimal Deviation: One
Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 2 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n m a n y c a s e s , i n a d d i t i o n t o t h e r i s k c o n s t r a i n t , t h e i n v e s t o r f a c e s a b u d g e t
c o n s t r a i n t w h i c h f o r c e s t h e s u m o f t h e t o t a l p o r t f o l i o w e i g h t s t o b e o n e .
W i t h t h i s c o n s t r a i n t , t h e r e i s a s p e c i a l g l o b a l m i n i m u m - v a r i a n c e p o r t f o l i o
w h i c h m i n i m i z e s t h e v a r i a n c e a m o n g a l l p o s s i b l e p o r t f o l i o s s a t i s f y i n g t h e
b u d g e t c o n s t r a i n t . U n d e r b o t h t h e b u d g e t c o n s t r a i n t a n d t h e r i s k c o n s t r a i n t ,
t h e o p t i m a l p o r t f o l i o i s a l i n e a r c o m b i n a t i o n o f t h e u n c o n s t r a i n e d o p t i m a l
p o r t f o l i o a n d t h e g l o b a l m i n i m u m v a r i a n c e p o r t f o l i o . T h e p a r a m e t e r s a r e
c h o s e n i n t h e w a y t h a t t h e c o m b i n a t i o n s a t i s f i e s b o t h t h e r i s k c o n s t r a i n t a n d
t h e b u d g e t c o n s t r a i n t ( C h a r t 6 ) .
R i s k a n d B u d g e t C o n s t r a i n e d
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
I n t h e l a s t e x a m p l e , a b e t a c o n s t r a i n t i s a d d e d t o t h e b u d g e t a n d r i s k
c o n s t r a i n t s . A b e t a c o n s t r a i n t f o r c e s t h e b e t a o f t h e p o r t f o l i o w i t h r e s p e c t t o
t h e m a r k e t p o r t f o l i o t o b e o n e . I t c a n b e s h o w n t h a t t h e o p t i m a l p o r t f o l i o
u n d e r a l l t h r e e c o n s t r a i n t s r i s k , b u d g e t , a n d b e t a i s a l i n e a r c o m b i n a t i o n
o f t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o , t h e m i n i m u m - v a r i a n c e p o r t f o l i o , a n d
t h e m a r k e t e q u i l i b r i u m p o r t f o l i o . T h e p a r a m e t e r s a r e a d j u s t e d i n a w a y t h a t
a l l t h r e e c o n s t r a i n t s a r e s a t i s f i e d ( C h a r t 7 ) .
B u d g e t C o n s t r a i n t
B e t a C o n s t r a i n t
______________________________________________ 11 ____________________________________________
Model Portfolios
All these examples display a very important property of the Black-
Litterman model: an unconstrained investor using the model will invest first
in the market portfolio, then in the portfolios representing the views. She
will never deviate from the market capitalization-weighted portfolio on the
assets about which she does not have views.
Arriving at the optimal portfolio is somewhat more complex in the presence
of constraints. In general, when there are constraints, the easiest way to
find the optimal portfolio is to use the Black-Litterman model to generate
the expected returns for the assets, and then use a mean-variance optimizer
to solve the constrained optimization problem. In these situations, the
intuition of the Black-Litterman model is more difficult to see. However,
one can see the intuition in slightly modified forms in a few special
constrained cases.
7
Again, the portfolios about which the investor has
views play a critical role in the optimal portfolio construction, even in the
constrained case.
In the case of having a risk constraint, the investors objective of selecting
the optimal portfolio is to maximize the expected return while keeping the
volatility of the portfolio under the given level. In this case, the optimal
portfolio can be found by scaling the solution of the unconstrained
optimization problem to the desired risk level. In Chart 3A, the investor
has two views. If the investor is targeting a risk level of 20% per annum,
she can calculate the constrained optimal portfolio weights by taking the
unconstrained optimal weights, multiplying it by the ratio of the targeted
risk level of 20% and the volatility of the unconstrained optimal portfolio.
However, because of the scaling, the deviation from the equilibrium is no
longer a weighted sum of the Germany/Europe portfolio and the
Canada/USA portfolio only. It has additional exposure coming from the
scaling of the market equilibrium portfolio (Chart 5).
Chart 5. Black-Litterman Model with Two Views, Risk Constrained
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights

7
The solutions to the unconstrained optimization problem as well as to several special constrained optimization problems are given in
Appendix C.
The Constrained Optimal
Portfolio
Risk Constraint
B
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______________________________________________ 7 ____________________________________________
Model Portfolios
From the graph of the expected returns in Chart 2A, it seems counter-
intuitive to see that the expected returns for both France and the United
Kingdom are raised. On the contrary, the view expressed does not say
France or the United Kingdom will go down, it only says that they will
under-perform Germany. Since both France and the United Kingdom are
positively correlated with the view portfolio and the view raises the
expected return of this portfolio, it is natural to see the expected returns on
France and the United Kingdom increase as well. The same intuition
applies to the other countries in Chart 2A.
Chart 2A. Expected Returns, Black-Litterman Model
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Black-Litterman E.R.
The optimal portfolio weights in Chart 2B are computed by solving the
maximization problem. Compared to the equilibrium weights, the optimal
portfolio increases the weight in Germany and decreases the weights in
both France and the United Kingdom. One can see that the deviations from
the equilibrium weights are proportional to the portfolio of long Germany
and short France and the United Kingdomexactly the portfolio
representing the investors view. This result is very intuitive. Since the
investor has a view about this portfolio, she simply invests in this portfolio,
on top of her neutral weights, the equilibrium weights.
Optimal Portfolio Weights:
One Market View
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 8 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
C h a r t 2 B . O p t i m a l P o r t f o l i o W e i g h t s , B l a c k - L i t t e r m a n M o d e l
O n e V i e w o n G e r m a n y v e r s u s t h e R e s t o f E u r o p e
- 2 0 . 0 %
0 . 0 %
2 0 . 0 %
4 0 . 0 %
6 0 . 0 %
8 0 . 0 %
O p t i m a l P o r t f o l i o
I n C h a r t 2 C , o n e c a n s e e t h a t t h e d e v i a t i o n s o f t h e o p t i m a l p o r t f o l i o f r o m
t h e e q u i l i b r i u m w e i g h t s a r e e x a c t l y p r o p o r t i o n a l t o t h e p o r t f o l i o o f a l o n g
p o s i t i o n i n G e r m a n y a n d a s h o r t p o s i t i o n o f m a r k e t c a p i t a l i z a t i o n - w e i g h t e d
F r a n c e a n d t h e U n i t e d K i n g d o m . T h i s r e s u l t i s n o t c o i n c i d e n t a l , a s i t
i l l u s t r a t e s a v e r y i m p o r t a n t p r o p e r t y o f t h e B l a c k - L i t t e r m a n m o d e l . I n
g e n e r a l , t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o f r o m t h e B l a c k - L i t t e r m a n
m o d e l i s t h e m a r k e t e q u i l i b r i u m p o r t f o l i o p l u s a w e i g h t e d s u m o f t h e
p o r t f o l i o s a b o u t w h i c h t h e i n v e s t o r h a s v i e w s .
C h a r t 2 C . O p t i m a l D e v i a t i o n s f r o m E q u i l i b r i u m W e i g h t s
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
O p t i m a l D e v i a t i o n : O n e
M a r k e t V i e w
______________________________________________ 12 ____________________________________________
Model Portfolios
In many cases, in addition to the risk constraint, the investor faces a budget
constraint which forces the sum of the total portfolio weights to be one.
With this constraint, there is a special global minimum-variance portfolio
which minimizes the variance among all possible portfolios satisfying the
budget constraint. Under both the budget constraint and the risk constraint,
the optimal portfolio is a linear combination of the unconstrained optimal
portfolio and the global minimum variance portfolio. The parameters are
chosen in the way that the combination satisfies both the risk constraint and
the budget constraint (Chart 6).
Risk and Budget Constrained
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights
In the last example, a beta constraint is added to the budget and risk
constraints. A beta constraint forces the beta of the portfolio with respect to
the market portfolio to be one. It can be shown that the optimal portfolio
under all three constraintsrisk, budget, and betais a linear combination
of the unconstrained optimal portfolio, the minimum-variance portfolio, and
the market equilibrium portfolio. The parameters are adjusted in a way that
all three constraints are satisfied (Chart 7).
Budget Constraint
Beta Constraint
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 1 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A l l t h e s e e x a m p l e s d i s p l a y a v e r y i m p o r t a n t p r o p e r t y o f t h e B l a c k -
L i t t e r m a n m o d e l : a n u n c o n s t r a i n e d i n v e s t o r u s i n g t h e m o d e l w i l l i n v e s t f i r s t
i n t h e m a r k e t p o r t f o l i o , t h e n i n t h e p o r t f o l i o s r e p r e s e n t i n g t h e v i e w s . S h e
w i l l n e v e r d e v i a t e f r o m t h e m a r k e t c a p i t a l i z a t i o n - w e i g h t e d p o r t f o l i o o n t h e
a s s e t s a b o u t w h i c h s h e d o e s n o t h a v e v i e w s .
A r r i v i n g a t t h e o p t i m a l p o r t f o l i o i s s o m e w h a t m o r e c o m p l e x i n t h e p r e s e n c e
o f c o n s t r a i n t s . I n g e n e r a l , w h e n t h e r e a r e c o n s t r a i n t s , t h e e a s i e s t w a y t o
f i n d t h e o p t i m a l p o r t f o l i o i s t o u s e t h e B l a c k - L i t t e r m a n m o d e l t o g e n e r a t e
t h e e x p e c t e d r e t u r n s f o r t h e a s s e t s , a n d t h e n u s e a m e a n - v a r i a n c e o p t i m i z e r
t o s o l v e t h e c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m . I n t h e s e s i t u a t i o n s , t h e
i n t u i t i o n o f t h e B l a c k - L i t t e r m a n m o d e l i s m o r e d i f f i c u l t t o s e e . H o w e v e r ,
o n e c a n s e e t h e i n t u i t i o n i n s l i g h t l y m o d i f i e d f o r m s i n a f e w s p e c i a l
c o n s t r a i n e d c a s e s .
7
A g a i n , t h e p o r t f o l i o s a b o u t w h i c h t h e i n v e s t o r h a s
v i e w s p l a y a c r i t i c a l r o l e i n t h e o p t i m a l p o r t f o l i o c o n s t r u c t i o n , e v e n i n t h e
c o n s t r a i n e d c a s e .
I n t h e c a s e o f h a v i n g a r i s k c o n s t r a i n t , t h e i n v e s t o r s o b j e c t i v e o f s e l e c t i n g
t h e o p t i m a l p o r t f o l i o i s t o m a x i m i z e t h e e x p e c t e d r e t u r n w h i l e k e e p i n g t h e
v o l a t i l i t y o f t h e p o r t f o l i o u n d e r t h e g i v e n l e v e l . I n t h i s c a s e , t h e o p t i m a l
p o r t f o l i o c a n b e f o u n d b y s c a l i n g t h e s o l u t i o n o f t h e u n c o n s t r a i n e d
o p t i m i z a t i o n p r o b l e m t o t h e d e s i r e d r i s k l e v e l . I n C h a r t 3 A , t h e i n v e s t o r
h a s t w o v i e w s . I f t h e i n v e s t o r i s t a r g e t i n g a r i s k l e v e l o f 2 0 % p e r a n n u m ,
s h e c a n c a l c u l a t e t h e c o n s t r a i n e d o p t i m a l p o r t f o l i o w e i g h t s b y t a k i n g t h e
u n c o n s t r a i n e d o p t i m a l w e i g h t s , m u l t i p l y i n g i t b y t h e r a t i o o f t h e t a r g e t e d
r i s k l e v e l o f 2 0 % a n d t h e v o l a t i l i t y o f t h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o .
H o w e v e r , b e c a u s e o f t h e s c a l i n g , t h e d e v i a t i o n f r o m t h e e q u i l i b r i u m i s n o
l o n g e r a w e i g h t e d s u m o f t h e G e r m a n y / E u r o p e p o r t f o l i o a n d t h e
C a n a d a / U S A p o r t f o l i o o n l y . I t h a s a d d i t i o n a l e x p o s u r e c o m i n g f r o m t h e
s c a l i n g o f t h e m a r k e t e q u i l i b r i u m p o r t f o l i o ( C h a r t 5 ) .
C h a r t 5 . B l a c k - L i t t e r m a n M o d e l w i t h T w o V i e w s , R i s k C o n s t r a i n e d
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %

7
T h e s o l u t i o n s t o t h e u n c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m a s w e l l a s t o s e v e r a l s p e c i a l c o n s t r a i n e d o p t i m i z a t i o n p r o b l e m s a r e g i v e n i n
A p p e n d i x C .
T h e C o n s t r a i n e d O p t i m a l
P o r t f o l i o
R i s k C o n s t r a i n t
B
A
C
K

L
E
F
T
S
I
D
E
B
L
A
C
K
B
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E
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E
D
G
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E
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______________________________________________ 13 ____________________________________________
Model Portfolios
Risk, Budget, and Beta Constrained
-75.0%
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
Equilibrium Weights
8
factors.

8
This group is part of the Quantitative Resources Group and was formerly known as Quantitative Research.
______________________________________________ 5 ____________________________________________
Model Portfolios
Chart 1C shows the optimal portfolio weights computed by solving the
mean-variance problem. Using the equilibrium expected returns, the
optimal portfolio weights are the market portfolio weights. However, when
the view about Germany versus the rest of Europe is incorporated, even
though the changes of the expected returns from the equilibrium expected
returns are small and are limited for European countries only, the optimal
portfolio is quite different from what one would have expected: the
increased weight in the German market and the decreased weights in the
United Kingdom and France markets are expected, but the reduced weights
in Australia and Canada and the increased weights in Japan and the
United States are very puzzling. Since the investor does not have any view
on these countries, why should she adjust the weight in these countries?
Presumably it is because of the way the views are being translated into
expected returns. As we can see, the investor has already tried to translate
the view into the expected returns. Can she possibly do better?
Chart 1C. Optimal Portfolio Weights, Traditional Mean-Variance Approach
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
Equilibrium Weights
The Black-Litterman asset allocation model addresses those practical issues
in using the Markowitz framework by allowing the portfolio manager to
express views about portfolios, rather than a complete vector of expected
returns on all assets. In the simplest of contextswhen there is no
benchmark or constraintsthe optimal portfolio is very intuitive. It is
simply a set of deviations from market capitalization weights in the
directions of portfolios about which views are expressed. Here the Black-
Litterman model provides the appropriate weights on the portfolios, based
on stated expected returns on the portfolios and degrees of confidence in
these views. The model balances the contribution to expected return of
each of the portfolios about which a view is expressed against its
contribution to overall portfolio risk. These results are transparent and
intuitive.
Determining Optimal
Portfolio Weights
The Black-Litterman Asset
Allocation Model
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 2 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
S i n c e p u b l i c a t i o n i n 1 9 9 0 , t h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l h a s
g a i n e d w i d e a p p l i c a t i o n i n m a n y f i n a n c i a l i n s t i t u t i o n s . A s d e v e l o p e d i n t h e
o r i g i n a l p a p e r , t h e B l a c k - L i t t e r m a n m o d e l p r o v i d e s t h e f l e x i b i l i t y t o
c o m b i n e t h e m a r k e t e q u i l i b r i u m w i t h a d d i t i o n a l m a r k e t v i e w s o f t h e
i n v e s t o r . I n t h e B l a c k - L i t t e r m a n m o d e l , t h e u s e r i n p u t s a n y n u m b e r o f
v i e w s o r s t a t e m e n t s a b o u t t h e e x p e c t e d r e t u r n s o f a r b i t r a r y p o r t f o l i o s , a n d
t h e m o d e l c o m b i n e s t h e v i e w s w i t h e q u i l i b r i u m , p r o d u c i n g b o t h t h e s e t o f
e x p e c t e d r e t u r n s o f a s s e t s a s w e l l a s t h e o p t i m a l p o r t f o l i o w e i g h t s .
I n c o n t r a s t t o t h e B l a c k - L i t t e r m a n m o d e l , i n t h e t r a d i t i o n a l m e a n - v a r i a n c e
a p p r o a c h t h e u s e r i n p u t s a c o m p l e t e s e t o f e x p e c t e d r e t u r n s
1
, a n d t h e
p o r t f o l i o o p t i m i z e r g e n e r a t e s t h e o p t i m a l p o r t f o l i o w e i g h t s . H o w e v e r ,
u s e r s o f t h e s t a n d a r d p o r t f o l i o o p t i m i z e r s o f t e n f i n d t h a t t h e i r s p e c i f i c a t i o n
o f e x p e c t e d r e t u r n s p r o d u c e s o u t p u t p o r t f o l i o w e i g h t s w h i c h m a y n o t m a k e
s e n s e ( d u e t o t h e c o m p l e x m a p p i n g b e t w e e n e x p e c t e d r e t u r n s a n d p o r t f o l i o
w e i g h t s a n d t h e a b s e n c e o f a n a t u r a l s t a r t i n g p o i n t f o r t h e e x p e c t e d r e t u r n
a s s u m p t i o n s ) .
I n t h i s a r t i c l e , w e u s e e x a m p l e s t o i l l u s t r a t e t h e d i f f e r e n c e b e t w e e n t h e
t r a d i t i o n a l m e a n - v a r i a n c e o p t i m i z a t i o n p r o c e s s a n d t h e B l a c k - L i t t e r m a n
p r o c e s s . I n s o d o i n g , w e d e m o n s t r a t e h o w t h e B l a c k - L i t t e r m a n a p p r o a c h
2
p r o v i d e s b o t h a r e f e r e n c e p o i n t f o r e x p e c t e d r e t u r n a s s u m p t i o n s a s w e l l a s a
s y s t e m a t i c a p p r o a c h t o d e v i a t i n g f r o m t h i s p o i n t t o e x p r e s s o n e s m a r k e t
v i e w s .
T h e M a r k o w i t z f o r m u l a t i o n o f t h e p o r t f o l i o o p t i m i z a t i o n p r o b l e m i s a
b r i l l i a n t q u a n t i f i c a t i o n o f t h e t w o b a s i c o b j e c t i v e s o f i n v e s t i n g : m a x i m i z i n g
e x p e c t e d r e t u r n a n d m i n i m i z i n g r i s k . H a v i n g f o r m e d t h e f o u n d a t i o n o f
p o r t f o l i o t h e o r y f o r t h e n e a r l y h a l f a c e n t u r y s i n c e i t s p u b l i c a t i o n , t h i s
f r a m e w o r k h a s s t o o d t h e t e s t o f t i m e i n t h e a c a d e m i c w o r l d . U n f o r t u n a t e l y ,
i n t h e p r a c t i c a l w o r l d o f i n v e s t m e n t m a n a g e m e n t , t h e M a r k o w i t z
f r a m e w o r k h a s h a d s u r p r i s i n g l y l i t t l e i m p a c t . W h y i s t h a t t h e c a s e ? W e c i t e
t w o r e a s o n s .
F i r s t , i n v e s t m e n t m a n a g e r s t e n d t o f o c u s o n s m a l l s e g m e n t s o f t h e i r
p o t e n t i a l i n v e s t m e n t u n i v e r s e p i c k i n g s t o c k s a n d o t h e r a s s e t s t h a t t h e y
f e e l a r e u n d e r v a l u e d , f i n d i n g a s s e t s w i t h p o s i t i v e m o m e n t u m , o r i d e n t i f y i n g
r e l a t i v e v a l u e t r a d e s . U n f o r t u n a t e l y , t h e M a r k o w i t z f o r m u l a t i o n
u n r e a l i s t i c a l l y r e q u i r e s e x p e c t e d r e t u r n s t o b e s p e c i f i e d f o r e v e r y
c o m p o n e n t o f t h e r e l e v a n t u n i v e r s e , w h i c h i n p r a c t i c e i s t y p i c a l l y d e f i n e d
b y a b r o a d b e n c h m a r k .

1
T h r o u g h o u t t h i s p a p e r f o r s i m p l i c i t y w e u s e t h e p h r a s e e x p e c t e d r e t u r n t o r e f e r t o e x p e c t e d e x c e s s r e t u r n o v e r t h e o n e - p e r i o d r i s k -
f r e e r a t e .
2
T h e B l a c k - L i t t e r m a n m o d e l s t a r t s w i t h e q u i l i b r i u m e x p e c t e d r e t u r n s ( a s d e r i v e d v i a t h e C a p i t a l A s s e t P r i c i n g M o d e l ) . T h i s s e t o f
e x p e c t e d r e t u r n s i s t h e n e u t r a l r e f e r e n c e p o i n t o f t h e B l a c k - L i t t e r m a n m o d e l .
E x e c u t i v e S u m m a r y
T h e T r a d i t i o n a l M e a n -
V a r i a n c e A p p r o a c h
______________________________________________ 14 ____________________________________________
Model Portfolios
Instead of treating the Black-Litterman asset allocation model as a black
box which generates expected returns in some mysterious way, we have
presented a method to understand the intuition of the model. With the new
method, investing using the Black-Litterman model becomes very intuitive.
The investor should invest in the market portfolio first, then deviate from
market weights by adding weights on portfolios representing her views.
The Black-Litterman model gives the optimal weights for these portfolios.
When the investor has constraints, or a different risk tolerance level from
the world average, she can always use the expected returns (generated by
the Black-Litterman model along with the covariance matrix) in a portfolio
optimization package to obtain the optimal portfolio. Unlike a standard
mean-variance optimization, the Black-Litterman model, if properly
implemented, will always generate an optimal portfolio whose weights are
relatively easy to understand.
Conclusion
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 7 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A p p e n d i x B
1 . T h e r e a r e N a s s e t s i n t h e m a r k e t . T h e m a r k e t p o r t f o l i o ( e q u i l i b r i u m p o r t f o l i o ) i s w
e q
. T h e c o v a r i a n c e o f
t h e r e t u r n s i s . T h e e x p e c t e d r e t u r n s : i s a v e c t o r o f n o r m a l l y d i s t r i b u t e d r a n d o m v a r i a b l e s w i t h
m e a n .
2 . T h e a v e r a g e r i s k t o l e r a n c e o f t h e w o r l d i s r e p r e s e n t e d b y t h e r i s k - a v e r s i o n p a r a m e t e r . T h e e q u i l i b r i u m
e x p e c t e d r e t u r n s a r e = w
e q
. T h e C A P M p r i o r d i s t r i b u t i o n f o r t h e e x p e c t e d r e t u r n s i s = +
( )e
, w h e r e
( )e
i s n o r m a l l y d i s t r i b u t e d w i t h m e a n z e r o a n d c o v a r i a n c e . T h e p a r a m e t e r i s a s c a l a r m e a s u r i n g t h e
u n c e r t a i n t y o f t h e C A P M p r i o r .
3 . T h e u s e r h a s K v i e w s a b o u t t h e m a r k e t , e x p r e s s e d a s P Q
v
= +
( )
, w h e r e P i s a K N m a t r i x a n d Q i s
K - v e c t o r , a n d
( )v
i s n o r m a l l y d i s t r i b u t e d w i t h m e a n z e r o a n d c o v a r i a n c e . T h e u s e r s v i e w s a r e
i n d e p e n d e n t o f t h e C A P M p r i o r a n d i n d e p e n d e n t o f e a c h o t h e r .
4 . T h e m e a n o f t h e e x p e c t e d r e t u r n s i s
( )
[ ]
( )
[ ] = + +

1 1
1
1 1
P P P Q .
5 . T h e i n v e s t o r h a s t h e w o r l d a v e r a g e r i s k t o l e r a n c e . T h e o b j e c t i v e o f t h e i n v e s t o r i s t o m a x i m i z e t h e u t i l i t y
w w w' ' 2 . T h e u n c o n s t r a i n e d o p t i m a l p o r t f o l i o i s w
*
=
1
, w h i c h c a n b e w r i t t e n a s
w w P
e q
*
= + . S i n c e t h e c o l u m n s o f m a t r i x P a r e t h e p o r t f o l i o s i n t h e u s e r s v i e w , t h i s m e a n s t h a t t h e
u n c o n s t r a i n e d o p t i m a l p o r t f o l i o i s t h e m a r k e t p o r t f o l i o p l u s a w e i g h t e d s u m o f t h e p o r t f o l i o s i n t h e u s e r s
v i e w s . T h e w e i g h t s f o r t h e s e p o r t f o l i o s a r e g i v e n b y t h e e l e m e n t s o f t h e v e c t o r , w h i c h i s g i v e n b y t h e
f o r m u l a
[ ] [ ]
= + +

1
1 1
1
Q P P P w P P P P Q
e q
.
6 . L e t P , Q , a n d r e p r e s e n t t h e K v i e w s h e l d b y t h e i n v e s t o r i n i t i a l l y , b e t h e e x p e c t e d r e t u r n s b y u s i n g
t h e s e v i e w s i n t h e B l a c k - L i t t e r m a n m o d e l , b e t h e w e i g h t v e c t o r d e f i n e d a b o v e . A s s u m e t h e i n v e s t o r n o w
h a s o n e a d d i t i o n a l v i e w , r e p r e s e n t e d b y p , q , a n d . F o r t h e n e w c a s e o f K + 1 v i e w s , t h e n e w w e i g h t
v e c t o r i s g i v e n b y t h e f o l l o w i n g f o r m u l a
( ) ( )( )
( ) ( )( )
'
'
q p A b c b A b
q p c b A b

1 1
1

w h e r e
A P P b P p c p p= + = = + , , . S i n c e c b A b >
1
0 , t h e e x p r e s s i o n o f s h o w s t h e a d d i t i o n a l
v i e w w i l l h a v e a p o s i t i v e ( n e g a t i v e ) w e i g h t i f q p > 0 ( q p < 0 ) , t h i s c o r r e s p o n d s t o t h e c a s e w h e r e
t h e n e w v i e w o n t h e p o r t f o l i o p i s m o r e b u l l i s h ( b e a r i s h ) t h a n i m p l i e d b y t h e o l d e x p e c t e d r e t u r n . T h e
a d d i t i o n a l v i e w w i l l h a v e a z e r o w e i g h t i f q p= , t h i s c o r r e s p o n d s t o t h e c a s e w h e r e t h e n e w v i e w i s
i m p l i e d b y t h e o l d e x p e c t e d r e t u r n s a l r e a d y . I n t h i s c a s e , t h e n e w v i e w h a s n o i m p a c t a t a l l .
7 . F o r a p a r t i c u l a r v i e w k , i t s w e i g h t
k
i s a n i n c r e a s i n g f u n c t i o n o f i t s e x p e c t e d r e t u r n q
k
. T h e a b s o l u t e
v a l u e o f
k
i s a n i n c r e a s i n g f u n c t i o n o f i t s c o n f i d e n c e l e v e l
k
1
.
B
A
C
K

R
I
G
H
T
S
I
D
E
B
L
A
C
K
B
L
U
E
R
E
D
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
S e c o n d , i n v e s t m e n t m a n a g e r s t e n d t o t h i n k i n t e r m s o f w e i g h t s i n a
p o r t f o l i o r a t h e r t h a n b a l a n c i n g e x p e c t e d r e t u r n s a g a i n s t t h e c o n t r i b u t i o n t o
p o r t f o l i o r i s k t h e r e l e v a n t m a r g i n i n t h e M a r k o w i t z f r a m e w o r k . W h e n
m a n a g e r s t r y t o o p t i m i z e u s i n g t h e M a r k o w i t z a p p r o a c h , t h e y u s u a l l y f i n d
t h a t t h e p o r t f o l i o w e i g h t s r e t u r n e d b y t h e o p t i m i z e r ( w h e n n o t o v e r l y
c o n s t r a i n e d ) t e n d t o a p p e a r t o b e e x t r e m e a n d n o t p a r t i c u l a r l y i n t u i t i v e . I n
p r a c t i c e m o s t m a n a g e r s f i n d t h a t t h e e f f o r t r e q u i r e d t o s p e c i f y e x p e c t e d
r e t u r n s a n d c o n s t r a i n t s t h a t l e a d t o r e a s o n a b l e a n s w e r s d o e s n o t l e a d t o a
c o m m e n s u r a t e b e n e f i t . I n d e e d t h i s w a s t h e o r i g i n a l m o t i v a t i o n f o r B l a c k
a n d L i t t e r m a n t o d e v e l o p t h e i r a p p r o a c h .
T h e f o l l o w i n g e x a m p l e d e m o n s t r a t e s t h e u n s t a b l e b e h a v i o r o f t h e o p t i m a l
w e i g h t s t h a t c a n o c c u r w h e n u s i n g o p t i m i z e r s . I n C h a r t 1 A , w e a s s u m e t h e
i n v e s t o r h a s o n l y o n e v i e w a b o u t t h e m a r k e t s : G e r m a n e q u i t y w i l l
o u t p e r f o r m E u r o p e a n e q u i t i e s b y 5 % p e r y e a r . S i n c e o u r i n v e s t o r d o e s n o t
h a v e a c o m p l e t e s e t o f e x p e c t e d r e t u r n s f o r a l l m a r k e t s , s h e s t a r t s b y s e t t i n g
t h e e x p e c t e d r e t u r n s f o r a l l c o u n t r i e s e q u a l t o 7 p e r c e n t . T o i n c o r p o r a t e h e r
v i e w , s h e t h e n s h i f t s t h e e x p e c t e d r e t u r n f o r G e r m a n y u p b y 2 . 5 % a n d
s h i f t s t h e e x p e c t e d r e t u r n f o r F r a n c e a n d t h e U n i t e d K i n g d o m d o w n b y
2 . 5 p e r c e n t .
W h a t t h i s i n v e s t o r f i n d s i s t h a t u s i n g e q u a l m e a n s d o e s n o t c o m p e n s a t e f o r
t h e d i f f e r e n t l e v e l s o f r i s k i n a s s e t s o f d i f f e r e n t c o u n t r i e s a n d t e n d s t o
g e n e r a t e v e r y e x t r e m e p o r t f o l i o s . C h a r t 1 A s h o w s t h a t u s i n g t h e e q u a l
e x p e c t e d r e t u r n s a s t h e s t a r t i n g p o i n t r e s u l t s i n o p t i m a l w e i g h t s o f - 3 3 . 5 %
i n G e r m a n y a n d 7 1 . 4 % i n A u s t r a l i a . A s m a l l s h i f t i n t h e e x p e c t e d r e t u r n s
f o r t h e E u r o p e a n e q u i t i e s ( 2 . 5 % f o r G e r m a n y , - 2 . 5 % f o r F r a n c e a n d t h e
U n i t e d K i n g d o m ) c a u s e s h u g e s w i n g s i n t h e w e i g h t s f o r t h e s e c o u n t r i e s .
T h e w e i g h t f o r F r a n c e n o w i s - 9 4 . 8 p e r c e n t !
C h a r t 1 A . O p t i m a l W e i g h t s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
S t a r t i n g f r o m E q u a l E x p e c t e d R e t u r n s
7 1 . 4 %
- 3 3 . 5 %
- 9 4 . 8 %
- 1 2 5 . 0 %
- 1 0 0 . 0 %
- 7 5 . 0 %
- 5 0 . 0 %
- 2 5 . 0 %
0 . 0 %
2 5 . 0 %
5 0 . 0 %
7 5 . 0 %
1 0 0 . 0 %
E q u a l E x p e c t e d R e t u r n s
E x p e c t e d R e t u r n s S h i f t e d f o r E u r o p e a n C o u n t r i e s
U n s t a b l e B e h a v i o r i n
P o r t f o l i o W e i g h t s u s i n g
O p t i m i z e r s
______________________________________________ 4 ____________________________________________
Model Portfolios
Black and Litterman also demonstrated the shortcomings of several other
methods for specifying a starting point for expected returns. They pointed
out that a better choice for the neutral expected returns is to use the
equilibrium expected returns as developed by Black. A major advantage of
this approach is that it results in market capitalization portfolio weights
being optimal for an investor using the mean-variance approach. Now,
armed with the equilibrium expected returns
3
as the neutral starting point,
the investor translates her view into expected returns.
There are many different ways to translate the view to expected returns.
For example, the investor could simply shift the expected return for
Germany to be 5% higher than the weighted average equilibrium expected
returns for the rest of Europe, but this approach may suggest that Germany
outperforms the rest of the world. To be precise in expressing her view,
she sets the expected return for Germany 5% higher than the (market
capitalization) weighted average of the expected returns of France and the
United Kingdom. She sets the sum of market capitalization-weighted
expected returns for the European countries as unchanged from the
equilibrium value. She keeps the difference between the expected returns
of France and the United Kingdom unchanged from the equilibrium
difference in value. Chart 1B demonstrates that since the equilibrium
already implies that Germany will outperform the rest of Europe, the
change in the expected returns is actually quite small.
Chart 1B. Expected Returns, Traditional Mean-Variance Approach
0
0.02
0.04
0.06
0.08
0.1
0.12
0.6%
1.7%
0.4%

3
Throughout our examples, we use = 2 5 . as the risk aversion parameter representing the world average risk tolerance.
Specifying a Starting Point
for Expected Returns
Translating Views into
Expected Returns
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 6 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
A p p e n d i x A
T a b l e 1 : A n n u a l i z e d v o l a t i l i t i e s , m a r k e t - c a p i t a l i z a t i o n w e i g h t s , a n d e q u i l i b r i u m e x p e c t e d r e t u r n s f o r t h e e q u i t y m a r k e t s i n
t h e s e v e n c o u n t r i e s .
C o u n t r y
E q u i t y I n d e x
V o l a t i l i t y ( % )
E q u i l i b r i u m P o r t f o l i o
W e i g h t ( % )
E q u i l i b r i u m E x p e c t e d
R e t u r n s ( % )
A u s t r a l i a 1 6 . 0 1 . 6 3 . 9
C a n a d a 2 0 . 3 2 . 2 6 . 9
F r a n c e 2 4 . 8 5 . 2 8 . 4
G e r m a n y 2 7 . 1 5 . 5 9 . 0
J a p a n 2 1 . 0 1 1 . 6 4 . 3
U K 2 0 . 0 1 2 . 4 6 . 8
U S A 1 8 . 7 6 1 . 5 7 . 6
T a b l e 2 : C o r r e l a t i o n s a m o n g t h e e q u i t y i n d e x r e t u r n s .
A u s t r a l i a C a n a d a F r a n c e G e r m a n y J a p a n U K
C a n a d a 0 . 4 8 8
F r a n c e 0 . 4 7 8 0 . 6 6 4
G e r m a n y 0 . 5 1 5 0 . 6 5 5 0 . 8 6 1
J a p a n 0 . 4 3 9 0 . 3 1 0 0 . 3 5 5 0 . 3 5 4
U K 0 . 5 1 2 0 . 6 0 8 0 . 7 8 3 0 . 7 7 7 0 . 4 0 5
U S A 0 . 4 9 1 0 . 7 7 9 0 . 6 6 8 0 . 6 5 3 0 . 3 0 6 0 . 6 5 2
______________________________________________ 15 ____________________________________________
Model Portfolios
General
This presentation does not constitute an offer or solicitation to any person in any jurisdiction in which such offer
or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or
solicitation. It is the responsibility of any person or persons in possession of this material to inform themselves
of and to observe all applicable laws and regulations of any relevant jurisdiction. Prospective investors should
inform themselves and take appropriate advice as to any applicable legal requirements and any applicable
taxation and exchange control regulations in the countries of their citizenship, residence or domicile which
might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments.
Information contained herein is believed to be reliable but no warranty is given as to its completeness or
accuracy and views and opinions, whilst given in good faith, are subject to change without notice. Members of
the Goldman Sachs Asset Management group of companies and their affiliates, connected persons and
employees may from time to time deal, hold or act as market-makers, advisers or brokers in relation to any
investments, or derivatives thereof, or be otherwise interested therein.
Past performance is not a guide to future performance and the value of investments and the income derived from
them can go down as well as up. Future returns are not guaranteed and a loss of principal may occur. Changes
in exchange rates may cause the value of an investment to increase or decrease. Some investments may be
restricted or illiquid, there may be no readily available market and there may be difficulty in obtaining reliable
information about their value and the extent of the risks to which such investments are exposed. Certain
investments, including warrants and similar securities, often involve a high degree of gearing or leverage so that
a relatively small movement in price of the underlying security or benchmark may result in a disproportionately
large movement, unfavourable as well as favourable, in the price of the warrant or similar security. In addition,
certain investments, including futures, swaps, forwards, certain options and derivatives, whether on or off
exchange, may involve contingent liability resulting in a need for the investor to pay more than the amount
originally invested and may possibly result in unquantifiable further loss exceeding the amount invested.
Transactions in over-the-counter derivatives involve additional risks as there is no market on which to close out
an open position; it may be impossible to liquidate an existing position, to assess the value of a position or to
assess the exposure to risk. Investors should carefully consider whether such investments are suitable for them
in light of their experience, circumstances and financial resources.
Opinions expressed are current opinions as of the date appearing in this material only. No part of this material
may be i) copied, photocopied or duplicated in any form, by any means, or ii) redistributed without Goldman
Sachs Asset Management's prior written consent.
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______________________________________________ 3 ____________________________________________
Model Portfolios
Second, investment managers tend to think in terms of weights in a
portfolio rather than balancing expected returns against the contribution to
portfolio riskthe relevant margin in the Markowitz framework. When
managers try to optimize using the Markowitz approach, they usually find
that the portfolio weights returned by the optimizer (when not overly
constrained) tend to appear to be extreme and not particularly intuitive. In
practice most managers find that the effort required to specify expected
returns and constraints that lead to reasonable answers does not lead to a
commensurate benefit. Indeed this was the original motivation for Black
and Litterman to develop their approach.
The following example demonstrates the unstable behavior of the optimal
weights that can occur when using optimizers. In Chart 1A, we assume the
investor has only one view about the markets: German equity will
outperform European equities by 5% per year. Since our investor does not
have a complete set of expected returns for all markets, she starts by setting
the expected returns for all countries equal to 7 percent. To incorporate her
view, she then shifts the expected return for Germany up by 2.5% and
shifts the expected return for France and the United Kingdom down by
2.5 percent.
What this investor finds is that using equal means does not compensate for
the different levels of risk in assets of different countries and tends to
generate very extreme portfolios. Chart 1A shows that using the equal
expected returns as the starting point results in optimal weights of -33.5%
in Germany and 71.4% in Australia. A small shift in the expected returns
for the European equities (2.5% for Germany, -2.5% for France and the
United Kingdom) causes huge swings in the weights for these countries.
The weight for France now is -94.8 percent!
Chart 1A. Optimal Weights, Traditional Mean-Variance Approach
Starting from Equal Expected Returns
71.4%
-33.5%
-94.8%
-125.0%
-100.0%
-75.0%
-50.0%
-25.0%
0.0%
25.0%
50.0%
75.0%
100.0%
Equal Expected Returns
Expected Returns Shifted for European Countries
Unstable Behavior in
Portfolio Weights using
Optimizers
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 4 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
B l a c k a n d L i t t e r m a n a l s o d e m o n s t r a t e d t h e s h o r t c o m i n g s o f s e v e r a l o t h e r
m e t h o d s f o r s p e c i f y i n g a s t a r t i n g p o i n t f o r e x p e c t e d r e t u r n s . T h e y p o i n t e d
o u t t h a t a b e t t e r c h o i c e f o r t h e n e u t r a l e x p e c t e d r e t u r n s i s t o u s e t h e
e q u i l i b r i u m e x p e c t e d r e t u r n s a s d e v e l o p e d b y B l a c k . A m a j o r a d v a n t a g e o f
t h i s a p p r o a c h i s t h a t i t r e s u l t s i n m a r k e t c a p i t a l i z a t i o n p o r t f o l i o w e i g h t s
b e i n g o p t i m a l f o r a n i n v e s t o r u s i n g t h e m e a n - v a r i a n c e a p p r o a c h . N o w ,
a r m e d w i t h t h e e q u i l i b r i u m e x p e c t e d r e t u r n s
3
a s t h e n e u t r a l s t a r t i n g p o i n t ,
t h e i n v e s t o r t r a n s l a t e s h e r v i e w i n t o e x p e c t e d r e t u r n s .
T h e r e a r e m a n y d i f f e r e n t w a y s t o t r a n s l a t e t h e v i e w t o e x p e c t e d r e t u r n s .
F o r e x a m p l e , t h e i n v e s t o r c o u l d s i m p l y s h i f t t h e e x p e c t e d r e t u r n f o r
G e r m a n y t o b e 5 % h i g h e r t h a n t h e w e i g h t e d a v e r a g e e q u i l i b r i u m e x p e c t e d
r e t u r n s f o r t h e r e s t o f E u r o p e , b u t t h i s a p p r o a c h m a y s u g g e s t t h a t G e r m a n y
o u t p e r f o r m s t h e r e s t o f t h e w o r l d . T o b e p r e c i s e i n e x p r e s s i n g h e r v i e w ,
s h e s e t s t h e e x p e c t e d r e t u r n f o r G e r m a n y 5 % h i g h e r t h a n t h e ( m a r k e t
c a p i t a l i z a t i o n ) w e i g h t e d a v e r a g e o f t h e e x p e c t e d r e t u r n s o f F r a n c e a n d t h e
U n i t e d K i n g d o m . S h e s e t s t h e s u m o f m a r k e t c a p i t a l i z a t i o n - w e i g h t e d
e x p e c t e d r e t u r n s f o r t h e E u r o p e a n c o u n t r i e s a s u n c h a n g e d f r o m t h e
e q u i l i b r i u m v a l u e . S h e k e e p s t h e d i f f e r e n c e b e t w e e n t h e e x p e c t e d r e t u r n s
o f F r a n c e a n d t h e U n i t e d K i n g d o m u n c h a n g e d f r o m t h e e q u i l i b r i u m
d i f f e r e n c e i n v a l u e . C h a r t 1 B d e m o n s t r a t e s t h a t s i n c e t h e e q u i l i b r i u m
a l r e a d y i m p l i e s t h a t G e r m a n y w i l l o u t p e r f o r m t h e r e s t o f E u r o p e , t h e
c h a n g e i n t h e e x p e c t e d r e t u r n s i s a c t u a l l y q u i t e s m a l l .
C h a r t 1 B . E x p e c t e d R e t u r n s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
0
0 . 0 2
0 . 0 4
0 . 0 6
0 . 0 8
0 . 1
0 . 1 2
0 . 6 %
1 . 7 %
0 . 4 %

3
T h r o u g h o u t o u r e x a m p l e s , w e u s e = 2 5. a s t h e r i s k a v e r s i o n p a r a m e t e r r e p r e s e n t i n g t h e w o r l d a v e r a g e r i s k t o l e r a n c e .
S p e c i f y i n g a S t a r t i n g P o i n t
f o r E x p e c t e d R e t u r n s
T r a n s l a t i n g V i e w s i n t o
E x p e c t e d R e t u r n s
______________________________________________ 16 ____________________________________________
Model Portfolios
Appendix A
Table 1: Annualized volatilities, market-capitalization weights, and equilibrium expected returns for the equity markets in
the seven countries.
Country
Equity Index
Volatility (%)
Equilibrium Portfolio
Weight (%)
Equilibrium Expected
Returns (%)
Australia 16.0 1.6 3.9
Canada 20.3 2.2 6.9
France 24.8 5.2 8.4
Germany 27.1 5.5 9.0
Japan 21.0 11.6 4.3
UK 20.0 12.4 6.8
USA 18.7 61.5 7.6
Table 2: Correlations among the equity index returns.
Australia Canada France Germany Japan UK
Canada 0.488
France 0.478 0.664
Germany 0.515 0.655 0.861
Japan 0.439 0.310 0.355 0.354
UK 0.512 0.608 0.783 0.777 0.405
USA 0.491 0.779 0.668 0.653 0.306 0.652
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 5 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
G e n e r a l
T h i s p r e s e n t a t i o n d o e s n o t c o n s t i t u t e a n o f f e r o r s o l i c i t a t i o n t o a n y p e r s o n i n a n y j u r i s d i c t i o n i n w h i c h s u c h o f f e r
o r s o l i c i t a t i o n i s n o t a u t h o r i z e d o r t o a n y p e r s o n t o w h o m i t w o u l d b e u n l a w f u l t o m a k e s u c h o f f e r o r
s o l i c i t a t i o n . I t i s t h e r e s p o n s i b i l i t y o f a n y p e r s o n o r p e r s o n s i n p o s s e s s i o n o f t h i s m a t e r i a l t o i n f o r m t h e m s e l v e s
o f a n d t o o b s e r v e a l l a p p l i c a b l e l a w s a n d r e g u l a t i o n s o f a n y r e l e v a n t j u r i s d i c t i o n . P r o s p e c t i v e i n v e s t o r s s h o u l d
i n f o r m t h e m s e l v e s a n d t a k e a p p r o p r i a t e a d v i c e a s t o a n y a p p l i c a b l e l e g a l r e q u i r e m e n t s a n d a n y a p p l i c a b l e
t a x a t i o n a n d e x c h a n g e c o n t r o l r e g u l a t i o n s i n t h e c o u n t r i e s o f t h e i r c i t i z e n s h i p , r e s i d e n c e o r d o m i c i l e w h i c h
m i g h t b e r e l e v a n t t o t h e s u b s c r i p t i o n , p u r c h a s e , h o l d i n g , e x c h a n g e , r e d e m p t i o n o r d i s p o s a l o f a n y i n v e s t m e n t s .
I n f o r m a t i o n c o n t a i n e d h e r e i n i s b e l i e v e d t o b e r e l i a b l e b u t n o w a r r a n t y i s g i v e n a s t o i t s c o m p l e t e n e s s o r
a c c u r a c y a n d v i e w s a n d o p i n i o n s , w h i l s t g i v e n i n g o o d f a i t h , a r e s u b j e c t t o c h a n g e w i t h o u t n o t i c e . M e m b e r s o f
t h e G o l d m a n S a c h s A s s e t M a n a g e m e n t g r o u p o f c o m p a n i e s a n d t h e i r a f f i l i a t e s , c o n n e c t e d p e r s o n s a n d
e m p l o y e e s m a y f r o m t i m e t o t i m e d e a l , h o l d o r a c t a s m a r k e t - m a k e r s , a d v i s e r s o r b r o k e r s i n r e l a t i o n t o a n y
i n v e s t m e n t s , o r d e r i v a t i v e s t h e r e o f , o r b e o t h e r w i s e i n t e r e s t e d t h e r e i n .
P a s t p e r f o r m a n c e i s n o t a g u i d e t o f u t u r e p e r f o r m a n c e a n d t h e v a l u e o f i n v e s t m e n t s a n d t h e i n c o m e d e r i v e d f r o m
t h e m c a n g o d o w n a s w e l l a s u p . F u t u r e r e t u r n s a r e n o t g u a r a n t e e d a n d a l o s s o f p r i n c i p a l m a y o c c u r . C h a n g e s
i n e x c h a n g e r a t e s m a y c a u s e t h e v a l u e o f a n i n v e s t m e n t t o i n c r e a s e o r d e c r e a s e . S o m e i n v e s t m e n t s m a y b e
r e s t r i c t e d o r i l l i q u i d , t h e r e m a y b e n o r e a d i l y a v a i l a b l e m a r k e t a n d t h e r e m a y b e d i f f i c u l t y i n o b t a i n i n g r e l i a b l e
i n f o r m a t i o n a b o u t t h e i r v a l u e a n d t h e e x t e n t o f t h e r i s k s t o w h i c h s u c h i n v e s t m e n t s a r e e x p o s e d . C e r t a i n
i n v e s t m e n t s , i n c l u d i n g w a r r a n t s a n d s i m i l a r s e c u r i t i e s , o f t e n i n v o l v e a h i g h d e g r e e o f g e a r i n g o r l e v e r a g e s o t h a t
a r e l a t i v e l y s m a l l m o v e m e n t i n p r i c e o f t h e u n d e r l y i n g s e c u r i t y o r b e n c h m a r k m a y r e s u l t i n a d i s p r o p o r t i o n a t e l y
l a r g e m o v e m e n t , u n f a v o u r a b l e a s w e l l a s f a v o u r a b l e , i n t h e p r i c e o f t h e w a r r a n t o r s i m i l a r s e c u r i t y . I n a d d i t i o n ,
c e r t a i n i n v e s t m e n t s , i n c l u d i n g f u t u r e s , s w a p s , f o r w a r d s , c e r t a i n o p t i o n s a n d d e r i v a t i v e s , w h e t h e r o n o r o f f
e x c h a n g e , m a y i n v o l v e c o n t i n g e n t l i a b i l i t y r e s u l t i n g i n a n e e d f o r t h e i n v e s t o r t o p a y m o r e t h a n t h e a m o u n t
o r i g i n a l l y i n v e s t e d a n d m a y p o s s i b l y r e s u l t i n u n q u a n t i f i a b l e f u r t h e r l o s s e x c e e d i n g t h e a m o u n t i n v e s t e d .
T r a n s a c t i o n s i n o v e r - t h e - c o u n t e r d e r i v a t i v e s i n v o l v e a d d i t i o n a l r i s k s a s t h e r e i s n o m a r k e t o n w h i c h t o c l o s e o u t
a n o p e n p o s i t i o n ; i t m a y b e i m p o s s i b l e t o l i q u i d a t e a n e x i s t i n g p o s i t i o n , t o a s s e s s t h e v a l u e o f a p o s i t i o n o r t o
a s s e s s t h e e x p o s u r e t o r i s k . I n v e s t o r s s h o u l d c a r e f u l l y c o n s i d e r w h e t h e r s u c h i n v e s t m e n t s a r e s u i t a b l e f o r t h e m
i n l i g h t o f t h e i r e x p e r i e n c e , c i r c u m s t a n c e s a n d f i n a n c i a l r e s o u r c e s .
O p i n i o n s e x p r e s s e d a r e c u r r e n t o p i n i o n s a s o f t h e d a t e a p p e a r i n g i n t h i s m a t e r i a l o n l y . N o p a r t o f t h i s m a t e r i a l
m a y b e i ) c o p i e d , p h o t o c o p i e d o r d u p l i c a t e d i n a n y f o r m , b y a n y m e a n s , o r i i ) r e d i s t r i b u t e d w i t h o u t G o l d m a n
S a c h s A s s e t M a n a g e m e n t ' s p r i o r w r i t t e n c o n s e n t .
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_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 5 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
C h a r t 1 C s h o w s t h e o p t i m a l p o r t f o l i o w e i g h t s c o m p u t e d b y s o l v i n g t h e
m e a n - v a r i a n c e p r o b l e m . U s i n g t h e e q u i l i b r i u m e x p e c t e d r e t u r n s , t h e
o p t i m a l p o r t f o l i o w e i g h t s a r e t h e m a r k e t p o r t f o l i o w e i g h t s . H o w e v e r , w h e n
t h e v i e w a b o u t G e r m a n y v e r s u s t h e r e s t o f E u r o p e i s i n c o r p o r a t e d , e v e n
t h o u g h t h e c h a n g e s o f t h e e x p e c t e d r e t u r n s f r o m t h e e q u i l i b r i u m e x p e c t e d
r e t u r n s a r e s m a l l a n d a r e l i m i t e d f o r E u r o p e a n c o u n t r i e s o n l y , t h e o p t i m a l
p o r t f o l i o i s q u i t e d i f f e r e n t f r o m w h a t o n e w o u l d h a v e e x p e c t e d : t h e
i n c r e a s e d w e i g h t i n t h e G e r m a n m a r k e t a n d t h e d e c r e a s e d w e i g h t s i n t h e
U n i t e d K i n g d o m a n d F r a n c e m a r k e t s a r e e x p e c t e d , b u t t h e r e d u c e d w e i g h t s
i n A u s t r a l i a a n d C a n a d a a n d t h e i n c r e a s e d w e i g h t s i n J a p a n a n d t h e
U n i t e d S t a t e s a r e v e r y p u z z l i n g . S i n c e t h e i n v e s t o r d o e s n o t h a v e a n y v i e w
o n t h e s e c o u n t r i e s , w h y s h o u l d s h e a d j u s t t h e w e i g h t i n t h e s e c o u n t r i e s ?
P r e s u m a b l y i t i s b e c a u s e o f t h e w a y t h e v i e w s a r e b e i n g t r a n s l a t e d i n t o
e x p e c t e d r e t u r n s . A s w e c a n s e e , t h e i n v e s t o r h a s a l r e a d y t r i e d t o t r a n s l a t e
t h e v i e w i n t o t h e e x p e c t e d r e t u r n s . C a n s h e p o s s i b l y d o b e t t e r ?
C h a r t 1 C . O p t i m a l P o r t f o l i o W e i g h t s , T r a d i t i o n a l M e a n - V a r i a n c e A p p r o a c h
- 4 0 . 0 %
- 2 0 . 0 %
0 . 0 %
2 0 . 0 %
4 0 . 0 %
6 0 . 0 %
8 0 . 0 %
T h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l a d d r e s s e s t h o s e p r a c t i c a l i s s u e s
i n u s i n g t h e M a r k o w i t z f r a m e w o r k b y a l l o w i n g t h e p o r t f o l i o m a n a g e r t o
e x p r e s s v i e w s a b o u t p o r t f o l i o s , r a t h e r t h a n a c o m p l e t e v e c t o r o f e x p e c t e d
r e t u r n s o n a l l a s s e t s . I n t h e s i m p l e s t o f c o n t e x t s w h e n t h e r e i s n o
b e n c h m a r k o r c o n s t r a i n t s t h e o p t i m a l p o r t f o l i o i s v e r y i n t u i t i v e . I t i s
s i m p l y a s e t o f d e v i a t i o n s f r o m m a r k e t c a p i t a l i z a t i o n w e i g h t s i n t h e
d i r e c t i o n s o f p o r t f o l i o s a b o u t w h i c h v i e w s a r e e x p r e s s e d . H e r e t h e B l a c k -
L i t t e r m a n m o d e l p r o v i d e s t h e a p p r o p r i a t e w e i g h t s o n t h e p o r t f o l i o s , b a s e d
o n s t a t e d e x p e c t e d r e t u r n s o n t h e p o r t f o l i o s a n d d e g r e e s o f c o n f i d e n c e i n
t h e s e v i e w s . T h e m o d e l b a l a n c e s t h e c o n t r i b u t i o n t o e x p e c t e d r e t u r n o f
e a c h o f t h e p o r t f o l i o s a b o u t w h i c h a v i e w i s e x p r e s s e d a g a i n s t i t s
c o n t r i b u t i o n t o o v e r a l l p o r t f o l i o r i s k . T h e s e r e s u l t s a r e t r a n s p a r e n t a n d
i n t u i t i v e .
D e t e r m i n i n g O p t i m a l
P o r t f o l i o W e i g h t s
T h e B l a c k - L i t t e r m a n A s s e t
A l l o c a t i o n M o d e l
______________________________________________ 2 ____________________________________________
Model Portfolios
Since publication in 1990, the Black-Litterman asset allocation model has
gained wide application in many financial institutions. As developed in the
original paper, the Black-Litterman model provides the flexibility to
combine the market equilibrium with additional market views of the
investor. In the Black-Litterman model, the user inputs any number of
views or statements about the expected returns of arbitrary portfolios, and
the model combines the views with equilibrium, producing both the set of
expected returns of assets as well as the optimal portfolio weights.
In contrast to the Black-Litterman model, in the traditional mean-variance
approach the user inputs a complete set of expected returns
1
, and the
portfolio optimizer generates the optimal portfolio weights. However,
users of the standard portfolio optimizers often find that their specification
of expected returns produces output portfolio weights which may not make
sense (due to the complex mapping between expected returns and portfolio
weights and the absence of a natural starting point for the expected return
assumptions).
In this article, we use examples to illustrate the difference between the
traditional mean-variance optimization process and the Black-Litterman
process. In so doing, we demonstrate how the Black-Litterman approach
2
provides both a reference point for expected return assumptions as well as a
systematic approach to deviating from this point to express ones market
views.
The Markowitz formulation of the portfolio optimization problem is a
brilliant quantification of the two basic objectives of investing: maximizing
expected return and minimizing risk. Having formed the foundation of
portfolio theory for the nearly half a century since its publication, this
framework has stood the test of time in the academic world. Unfortunately,
in the practical world of investment management, the Markowitz
framework has had surprisingly little impact. Why is that the case? We cite
two reasons.
First, investment managers tend to focus on small segments of their
potential investment universepicking stocks and other assets that they
feel are undervalued, finding assets with positive momentum, or identifying
relative value trades. Unfortunately, the Markowitz formulation
unrealistically requires expected returns to be specified for every
component of the relevant universe, which in practice is typically defined
by a broad benchmark.

1
Throughout this paper for simplicity we use the phrase expected return to refer to expected excess return over the one-period risk-
free rate.
2
The Black-Litterman model starts with equilibrium expected returns (as derived via the Capital Asset Pricing Model). This set of
expected returns is the neutral reference point of the Black-Litterman model.
Executive Summary
The Traditional Mean-
Variance Approach
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 1 4 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
I n s t e a d o f t r e a t i n g t h e B l a c k - L i t t e r m a n a s s e t a l l o c a t i o n m o d e l a s a b l a c k
b o x w h i c h g e n e r a t e s e x p e c t e d r e t u r n s i n s o m e m y s t e r i o u s w a y , w e h a v e
p r e s e n t e d a m e t h o d t o u n d e r s t a n d t h e i n t u i t i o n o f t h e m o d e l . W i t h t h e n e w
m e t h o d , i n v e s t i n g u s i n g t h e B l a c k - L i t t e r m a n m o d e l b e c o m e s v e r y i n t u i t i v e .
T h e i n v e s t o r s h o u l d i n v e s t i n t h e m a r k e t p o r t f o l i o f i r s t , t h e n d e v i a t e f r o m
m a r k e t w e i g h t s b y a d d i n g w e i g h t s o n p o r t f o l i o s r e p r e s e n t i n g h e r v i e w s .
T h e B l a c k - L i t t e r m a n m o d e l g i v e s t h e o p t i m a l w e i g h t s f o r t h e s e p o r t f o l i o s .
W h e n t h e i n v e s t o r h a s c o n s t r a i n t s , o r a d i f f e r e n t r i s k t o l e r a n c e l e v e l f r o m
t h e w o r l d a v e r a g e , s h e c a n a l w a y s u s e t h e e x p e c t e d r e t u r n s ( g e n e r a t e d b y
t h e B l a c k - L i t t e r m a n m o d e l a l o n g w i t h t h e c o v a r i a n c e m a t r i x ) i n a p o r t f o l i o
o p t i m i z a t i o n p a c k a g e t o o b t a i n t h e o p t i m a l p o r t f o l i o . U n l i k e a s t a n d a r d
m e a n - v a r i a n c e o p t i m i z a t i o n , t h e B l a c k - L i t t e r m a n m o d e l , i f p r o p e r l y
i m p l e m e n t e d , w i l l a l w a y s g e n e r a t e a n o p t i m a l p o r t f o l i o w h o s e w e i g h t s a r e
r e l a t i v e l y e a s y t o u n d e r s t a n d .
C o n c l u s i o n
______________________________________________ 17 ____________________________________________
Model Portfolios
Appendix B
1. There are N assets in the market. The market portfolio (equilibrium portfolio) is w
eq
. The covariance of
the returns is . The expected returns: is a vector of normally distributed random variables with
mean .
2. The average risk tolerance of the world is represented by the risk-aversion parameter . The equilibrium
expected returns are = w
eq
. The CAPM prior distribution for the expected returns is = +
( ) e
, where
( ) e
is normally distributed with mean zero and covariance . The parameter is a scalar measuring the
uncertainty of the CAPM prior.
3. The user has K views about the market, expressed as P Q
v
= +
( )
, where P is a K N matrix and Q is
K -vector, and
( ) v
is normally distributed with mean zero and covariance . The users views are
independent of the CAPM prior and independent of each other.
4. The mean of the expected returns is
( )
[ ]
( )
[ ] = + +

1 1
1
1 1
P P P Q .
5. The investor has the world average risk tolerance. The objective of the investor is to maximize the utility
w w w ' ' 2 . The unconstrained optimal portfolio is w
*
=

1
, which can be written as
w w P
eq
*
= + . Since the columns of matrix P are the portfolios in the users view, this means that the
unconstrained optimal portfolio is the market portfolio plus a weighted sum of the portfolios in the users
views. The weights for these portfolios are given by the elements of the vector , which is given by the
formula
[ ] [ ]
= + +

1
1 1
1
Q P P P w P P P P Q
eq
.
6. Let P , Q , and represent the K views held by the investor initially, be the expected returns by using
these views in the Black-Litterman model, be the weight vector defined above. Assume the investor now
has one additional view, represented by p , q , and . For the new case of K + 1 views, the new weight
vector is given by the following formula
( ) ( ) ( )
( ) ( ) ( )
'
'
q p A b c b A b
q p c b A b

1 1
1

where
A P P b P p c p p = + = = + , , . Since c b A b >
1
0 , the expression of shows the additional
view will have a positive (negative) weight if q p > 0 ( q p < 0 ), this corresponds to the case where
the new view on the portfolio p is more bullish (bearish) than implied by the old expected return . The
additional view will have a zero weight if q p = , this corresponds to the case where the new view is
implied by the old expected returns already. In this case, the new view has no impact at all.
7. For a particular viewk , its weight
k
is an increasing function of its expected return q
k
. The absolute
value of
k
is an increasing function of its confidence level
k
1
.
B
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K

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______________________________________________ 1 ____________________________________________
Model Portfolios
Investment Management Research
Goldman Sachs Quantitative Resources Group
Guangliang He (212) 357-3210
Robert Litterman (212) 902-1677
Copyright 1999 Goldman, Sachs & Co. All rights reserved.
The information in this publication is for your private information and is not intended as an offer or solicitation to buy or sell any securities.
The information in this publication is for your private information and should not be construed as financial advice and it is not intended as an offer or
solicitation to buy or sell any securities. The sole purpose of this publication is to inform the reader about the intuition behind the Black-Litterman model
portfolios and is not intended as a solicitation for any Goldman Sachs product or service.
______________________________________________ 18 ____________________________________________
Model Portfolios
Appendix C
1. Given the expected returns and the covariance matrix , the unconstrained maximization problem
max
w
w w w 2 has a solution of ( ) w* =

1
.
2. Given the covariance matrix , the minimum variance portfolio is
( )
w
m ( )
=

1 1
, where is a vector
with all elements being one.
3. The solution to the risk constrained optimization problem, max w , subject to w w
2
, can be expressed
as * * *
) (
w w w w
r
= , where ( ) w* =

1
is the solution of the unconstrained problem.
4. The risk and budget constrained optimization problem can be formulated as max w , subject to w w
2
and = w 1. Its solution has the form w aw bw
b m ( ) ( )
* = + , where a and b are chosen in the way both risk
and budget constraints are satisfied.
5. The risk-, budget-, and beta-constrained optimization problem can be formulated as max w , subject to
w w
2
, = w 1, and = w w w w
eq eq eq
, where w
eq
is the market portfolio. The solution to the problem
has the form of w aw bw cw
m
eq
( ) ( )
*
= + + , where a , b , and c are chosen in the way all three constraints are
satisfied.
References
[1] Black, Fischer and Robert Litterman, Asset Allocation: Combining Investor Views With Market Equilibrium,
Goldman, Sachs & Co., Fixed Income Research, September 1990.
[2] Black, Fischer and Robert Litterman, Global Portfolio Optimization, Financial Analysts Journal, pages 28-
43, September-October 1992.
[3] Black, Fischer, Universal Hedging: Optimizing Currency Risk and Reward in International Equity
Portfolios, Financial Analysts Journal, pages 16-22, July-August 1989.
[4] Litterman, Robert, Hot Spots and Hedges, The Journal of Portfolio Management, pages 52-75, December
1996.
[5] Markowitz, Harry, Portfolio Selection, Journal of Finance, pages 77-91, March 1952.
BACKS
Investment
Management
Division
The Intuition Behind Black-Litterman
Model Portfolios
I In this article and as our title suggests, we demonstrate a method for
understanding the intuition behind the Black-Litterman asset allocation model.
I To do this, we use examples to show the difference between the traditional mean-
variance optimization process and the Black-Litterman process. We show that the
mean-variance optimization process, while academically sound, can produce
results that are extreme and not particularly intuitive. In contrast, we show that
the optimal portfolios generated by the Black-Litterman process have a simple,
intuitive property:
The unconstrained optimal portfolio is the market equilibrium portfolio
plus a weighted sum of portfolios representing an investors views.
The weight on a portfolio representing a view is positive when the
view is more bullish than the one implied by the equilibrium and
other views.
The weight increases as the investor becomes more bullish on the
view as well as when the investor becomes more confident about
the view.
December 1999
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