The Black Litterman model was developed in 1990 at Goldman Sachs by Fischer Black and Robert Litterman and deals with two problems in classic portfolio optimization:
- First, a standard optimization model requires as inputs the expected returns for all assets and currencies. Thus investors must augment their views with a set of auxiliary assumptions, and the historical returns they often use for this purpose provide poor guides to future returns.
- Second, the optimal portfolio asset weights and currency positions of standard asset allocation models are extremely sensitive to the return assumptions used.
This article describes an approach that provides an intuitive solution to the two problems that have plagued quantitative asset allocation models. The key is combining two established tenets of modern portfolio theory-the mean-variance optimization framework of Markowitz and the capital asset pricing model (CAPM).
“Global Portfolio Optimization” by Fischer Black and Robert Litterman, Financial Analysts Journal, September 1992.