Investments, tenth edition

   Black-Litterman Asset Allocation Decision 

 Consider a portfolio manager laboring over    asset  allocation    to bills, bonds, and stocks 

for the next month. The risky portfolio will be constructed from bonds and stocks so as to 

maximize the Sharpe ratio. So far this is no more than the problem described in Section 7.3 

7

 Black and Litterman, “Global Portfolio Optimization.” 

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  C H A P T E R  

2 7

  The Theory of Active Portfolio Management 

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of Chapter 7. There, we were concerned with optimizing the portfolio given a set of data 

inputs. In real life, however, optimization using a given dataset is the least of the manager’s 

problems. The real issue that dogs any portfolio manager is how to come by that input data. 

Black and Litterman propose an approach that uses past data, equilibrium considerations, 

and the private views of the portfolio manager about the near future. 

 Data enters the BL model from two sources: history and forecasts, called  views,   about 

the future. The historical sample is used to estimate the covariance matrix of the asset 

classes involved in the asset allocation decision. The estimated covariance matrix, com-

bined with a model of equilibrium returns (for example, the CAPM) is used to produce 

baseline forecasts that would be the basis of a passive strategy. In the next step, views are 

introduced and quantified. The views represent a departure from the baseline forecast and 

result in a revised set of expected returns. With the new set of inputs (just as with alpha 

forecasts in the Treynor-Black model), an optimal risky portfolio is designed to replace the 

(no-longer-efficient) passive portfolio.