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Black-Litterman Asset Allocation Model
Black-Litterman Asset Allocation Model
Highly-concentrated portfolios
Extreme portfolios
Input-sensitivity
unstable
Estimation error maximization
Unintuitive
No way to incorporate investor’s view
No way to incorporate confidence level
No intuitive starting point for expected return.
Complete set of expected return is required.
Black-Litterman Model
Generalized Least
μComb
Square Estimator of μ
μComb
Combining Views (1)
{
Generalized Least
μComb
Square Estimator of μ
μComb
Combining Views (2)
Var(μComb)
Now we have a combined forecast of the expected
returns.
The next step is to do Markowitz Mean-Variance
Optimization.
Asset Class 1 2 3 4 5 6 7 8
1. US Bonds 0.001005 0.001328 -0.000579 -0.000675 0.000121 0.000128 -0.000445 -0.000437
2. Intl Bonds 0.001328 0.007277 -0.001307 -0.00061 -0.002237 -0.000989 0.001442 -0.001535
3. US Large Growth -0.000579 -0.001307 0.059852 0.027588 0.063497 0.023036 0.032967 0.048039
4. US Large Value -0.000675 -0.000610 0.027588 0.029609 0.026572 0.021465 0.020697 0.029854
5. US Small Growth 0.000121 -0.002237 0.063497 0.026572 0.102488 0.042744 0.039943 0.065994
6. US Small Value 0.000128 -0.000989 0.023036 0.021465 0.042744 0.032056 0.019881 0.032235
7. Int'l Dev. Equity -0.000445 0.001442 0.032967 0.020697 0.039943 0.019881 0.028355 0.035064
8. Int'l Emerg.Equity -0.000437 -0.001535 0.048039 0.029854 0.065994 0.032235 0.035064 0.079958
Market Returns П(nx1)
Π = λΣwmkt
Asset Class µHist µP Π
US Bonds 3.15% 0.08% 0.08%
Int’l Bonds 1.75% 0.67% 0.67%
US Large Growth -6.39% 6.41% 6.41%
US Large Value -2.86% 4.08% 4.08%
US Small Growth -6.75% 7.43% 7.43%
US Small Value -0.54% 3.70% 3.70%
Int’l Dev. Equity -6.75% 4.80% 4.80%
Int’l Emerg. Equity -5.26% 6.60% 6.60%
5.25% ε1
Q+ε= 0.25% + ε2
2.00% ε3
w =(λΣ) -1E[R]
Combined Return E[R] vs. Equil. Return Π
8%
Π E[R]
6%
4%
2%
0%
US Bonds Int ’l Bonds US La rge US La rge Va lue US S ma ll US S ma ll Va lue Int ’l De v. Equit y Int ’l Eme rg.
Growt h Growt h Equit y
Resulting Asset Allocations Changed A
Lot…
View 1 – Bullish view on Int’l Dev. Equity
View 2: Int’l bonds will outperform increases allocation.
US bonds less than market implied.
35%
Market Cap. Weight New Weight
30%
View 3 – Growth tilt towards value
25%
20%
15%
10%
5%
0%
US Bonds Int ’l Bonds US La rge US La rge Va lue US S ma ll US S ma ll Va lue Int ’l De v. Int ’l Eme rg.
Growt h Growt h Equit y Equit y
Part 4: BL in Practice
Applications
Just now we presented unconstrained optimization.
Mahalanobis Distance
By the way, this is your long list.
2nd:
To Corporate America
Quantitative Employee Selection
Do not ‘calculate’:
Compassion
Aesthetic Value
Intellectual Curiosity