3 - A demystification of the Black-Litterman model: Managing quantitative and traditional portfolio construction

Abstract

This chapter discusses the details of Bayesian portfolio construction procedures, which have become popular in the asset management industry as Black–Litterman models. It explains their construction and presents some extensions and states the models as valuable tools for financial management. The chapter presents examples of Bayesian asset allocation portfolio construction models and illustrates the combination of judgmental and quantitative views. The Black–Litterman model has the potential to integrate diverse approaches, based on a Bayesian methodology that effectively updates currently held opinions with data to form new opinions. It concludes by stating that these models are potentially of considerable importance in the management of the investment process in modern financial institutions where both viewpoints are represented. The discussion includes an exposition of these models for the possibility of application by readers. It presents a theorem of Bayes' and related aassumptions..