Investments, tenth edition

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7

  THIS CHAPTER CONSIDERS 

practical com-

plexities in the process of constructing opti-

mal portfolios. It might seem that the word 

“theory” in the chapter title is inconsistent 

with this practical goal, and that the forego-

ing chapters must already have exhausted 

the insight that theory can impart to portfo-

lio management in the field—the rest surely 

must rely on learning by doing. 

 We will see, however, that theory has a 

significant contribution to offer even when 

it comes to the daily grind of putting it all 

together. We begin with the Treynor-Black 

model that we first encountered in Chapter 8, 

now showing how to handle limited  precision 

in the forecasts of alpha values and the 

extreme portfolio positions often prescribed 

by the model. Armed with these insights, we 

present a prototype organizational chart and 

discuss the efficacy of fitting the organization 

to the theoretical underpinning of portfolio 

management. 

 In the next section, we present the Black-

Litterman model that allows flexible views 

about the expected returns of asset classes to 

improve asset allocation. Finally, we look into 

the potential profitability of security analysis 

and end with concluding remarks. An appen-

dix to the chapter presents the mathematics 

underlying the Black-Litterman model.  

 P

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T VII