The Black-Litterman asset allocation model provides a methodical way of combining an investor’s subjective views of the future performance of a risky investment asset with the views implied by the market equilibrium. The method has seen wide acceptance amongst practitioners as well as academics in spite of the fact that it originated as an internal Goldman Sachs working paper, rather than as a piece of research from academia.
The Black Litterman procedure can be viewed as a Bayesian shrinkage method, that shrinks the expected returns constructed from an investor’s views on asset returns towards asset returns implied by the market equilibrium. The procedure computes a set of expected returns that uses the market equilibrium implied as a prior. This is then combined with returns implied by subjective investor views to produce a set of posterior expected returns.
It was developed by Fischer Balck and Robert Litterman.
The model addresses the limitation of traditional mean-variance optimization which relies solely on historical returns.
Overall, the Black Litterman model provides a systematic framework for blending subjective views with market information, offering a robust and flexible approach to portfolio construction and risk management.
The attached document provides a detailed explanation of the mathematical framework underlying the model.
