Author Topic: Black - Litterman Model  (Read 1779 times)

shinn497

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Black - Litterman Model
« on: May 27, 2018, 08:10:00 PM »
Iw ould like to understand modern portfolio theory better. And I really want to understand the Black Litterman Model. I have read up on some papers but they leave a bit to be desired as I don't know some of the background knowledge like CAPM and such. Are there any courses or texts out there that are more thorough in terms of approaching this subject? Ideally something more pedagogical and with examples and case studies. This model has been around for a bit so I am curious if there is something out there.

FWIW I know linear algebra and matrix math pretty well, although material with a quick math primer would also be very much welcome.

SeattleCPA

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Re: Black - Litterman Model
« Reply #1 on: May 29, 2018, 07:30:49 AM »
If you don't know anything yet about MPT, you can get a quick handle on some of the math via this blog post I did about why 100% stocks portfolios don't make sense:

https://evergreensmallbusiness.com/100-stocks-allocation-suffers-two-big-flaws/

I.e., MPT's idea that you can probably or possibly earn a higher rate of return with the same level of risk is discussed in the "How to Earn a Higher Return" paragraphs... and MPT's idea that you can probably or possibly dial down your risks and earn the same return is discussed in the "How to Bear Less Risk" paragraphs.

William Bernstein's short book, Rational Expectations, also gives you some boots on the ground discussion about how practical it is to really apply MPT. That book is a good book to read... and then re-read:

https://www.amazon.com/Rational-Expectations-Allocation-Investing-Adults/dp/0988780321

BTW, I think Bernstein thinks MPT is great theory but that as a practical matter individual investors can't do much more than try to build diversified portfolios and then use riskless assets.

Tyler

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Re: Black - Litterman Model
« Reply #2 on: May 29, 2018, 11:12:37 AM »
Black-Litterman is a method for tweaking the expected returns inputs in a mean variance optimization model by layering confidence intervals over the long term averages. Basically, it’s a fancy academic term for predicting the future based on a personal guess. I’m a big believer in modern portfolio theory, and even I think most investors should pretty much ignore Black-Litterman as it’s way too deep in the weeds with highly questionable practical utility.

Also, “modern portfolio theory” is kindof a broad term and it’s important to understand that there are multiple approaches to the same concept of improving risk-adjusted returns. The most important ideas are less about optimization formulas and more about the measurable benefits of different types of diversification. I recommend starting out by learning a few core principles.  Here are a few recommended books:

“Fail Safe Investing” by Harry Browne does a great job of discussing how to diversify a portfolio to cover a variety of economic conditions.

“Your Complete Guide to Factor Based Investing” by Larry Swedroe covers how one can diversify their stock holdings using a variety of “factors” other than market Beta (the core CAPM metric behind the classic idea of adding bonds to reduce risk).

“Reducing the Risk of Black Swans”, also by Larry Swedroe, describes how portfolios can be constructed with a simple form of volatility-based risk parity to reduce risk for the same expected return.

And if you want an excellent history of economic theory, including examples of how many famous academic models are provably fundamentally flawed, check out “The Misbehavior of Markets” by Benoit Mandelbrot.

And of course, you can also try reading through the commentary and library at my personal site Portfolio Charts.  I study this type of stuff all the time and do my best to present it in an approachable way.  For the record, I don’t think any of the authors above has it all figured out on their own, but by reading different perspectives you can find something that works well for you personally not only financially but also intellectually and emotionally.

I hope that helps!

shinn497

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Re: Black - Litterman Model
« Reply #3 on: May 29, 2018, 11:29:07 AM »
Hey thanks guys! I will review these later. FWIW I want to understand this model better since it is what Betterment claims its portfolio is based on and I'm still evaluating if I should continue with them.

Tyler

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Re: Black - Litterman Model
« Reply #4 on: May 29, 2018, 12:09:27 PM »
Ah. Makes sense. Good for you to dig into their methodology rather than trusting them blindly.

I’m personally skeptical of the real-world usefulness of Black-Litterman, but for a supporting resource you might try this:  http://www.blacklitterman.org  I haven’t read it myself and can’t vouch for the information, but it looks very well-researched.
« Last Edit: May 29, 2018, 12:34:46 PM by Tyler »

shinn497

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Re: Black - Litterman Model
« Reply #5 on: May 29, 2018, 09:05:42 PM »
Ah. Makes sense. Good for you to dig into their methodology rather than trusting them blindly.

I’m personally skeptical of the real-world usefulness of Black-Litterman, but for a supporting resource you might try this:  http://www.blacklitterman.org  I haven’t read it myself and can’t vouch for the information, but it looks very well-researched.

Yeah I mean so far I agree with everything they do. At the very least, their allocation is close to the world's so it should approximate VTSAX but I want to be sure.

jacoavluha

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Re: Black - Litterman Model
« Reply #6 on: May 29, 2018, 09:31:28 PM »
Yeah I mean so far I agree with everything they do. At the very least, their allocation is close to the world's so it should approximate VTSAX but I want to be sure.

I presume by “they” you mean Betterment.

Their own reference is here: http://www.andreisimonov.com/NES/Litterman_Nomura.pdf

Basically, when talking equities, Betterment is tilted to small and value and emerging markets. Historically these have outperformed, relative to large and growth and developed. But with some added risk. This is widely known.

I think Betterment is a good product. But, I think a lot of the big names and references and fancy talk is really just “fluff” to make things seem complex and scientific and highly researched, so in the end you feel like you’re really getting your money’s worth for the fees they’re charging.

I would challenge your statement that their allocation is “close to the world’s” (it is not) or that it will “approximate VTSAX” (it will not). But, if you’re at Betterment, that shouldn’t be your goal anyway. If you want a total world index or a total US index, you can buy those directly elsewhere easily and for almost no cost.

shinn497

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Re: Black - Litterman Model
« Reply #7 on: May 29, 2018, 10:01:01 PM »
Well I have been looking at their weighting of securities and comparing it to The world index they reference. And it seems pretty close.

And yeah. I mean I'm not trying to buy VTSAX. I guess I meant that my initial thought is at least their portfolio will match the market, and maybe be less volatile.

I've looked at some of their critiques and reevaluating their portfolios and assumptions. It is clear that the assumptions their marketing puts front an center don't match up with everyone. But they do match close enough with my goal.

In the end, they seemed the most interesting since my hope with my bread and butter retirement account is to just forget about it. And maybe with them I'll feel a bit better and be able ot actually enjoy life. Then again it is also the inspriation to be hella nerdy so I am all about that. XD.


talltexan

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Re: Black - Litterman Model
« Reply #8 on: May 30, 2018, 06:56:31 AM »
If you don't know anything yet about MPT, you can get a quick handle on some of the math via this blog post I did about why 100% stocks portfolios don't make sense:

https://evergreensmallbusiness.com/100-stocks-allocation-suffers-two-big-flaws/

I.e., MPT's idea that you can probably or possibly earn a higher rate of return with the same level of risk is discussed in the "How to Earn a Higher Return" paragraphs... and MPT's idea that you can probably or possibly dial down your risks and earn the same return is discussed in the "How to Bear Less Risk" paragraphs.

William Bernstein's short book, Rational Expectations, also gives you some boots on the ground discussion about how practical it is to really apply MPT. That book is a good book to read... and then re-read:

https://www.amazon.com/Rational-Expectations-Allocation-Investing-Adults/dp/0988780321

BTW, I think Bernstein thinks MPT is great theory but that as a practical matter individual investors can't do much more than try to build diversified portfolios and then use riskless assets.

Thanks for sharing your blog post, I found it really quite informative. It reads like a stripped-down version of the column in which Paul Merriman discusses his ultimate buy-and-hold allocation, (I mean this positively) with an emphasis on the Risk versus Return tradeoff.

SeattleCPA

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Re: Black - Litterman Model
« Reply #9 on: May 30, 2018, 08:25:29 AM »
If you don't know anything yet about MPT, you can get a quick handle on some of the math via this blog post I did about why 100% stocks portfolios don't make sense:

https://evergreensmallbusiness.com/100-stocks-allocation-suffers-two-big-flaws/

I.e., MPT's idea that you can probably or possibly earn a higher rate of return with the same level of risk is discussed in the "How to Earn a Higher Return" paragraphs... and MPT's idea that you can probably or possibly dial down your risks and earn the same return is discussed in the "How to Bear Less Risk" paragraphs.

William Bernstein's short book, Rational Expectations, also gives you some boots on the ground discussion about how practical it is to really apply MPT. That book is a good book to read... and then re-read:

https://www.amazon.com/Rational-Expectations-Allocation-Investing-Adults/dp/0988780321

BTW, I think Bernstein thinks MPT is great theory but that as a practical matter individual investors can't do much more than try to build diversified portfolios and then use riskless assets.

Thanks for sharing your blog post, I found it really quite informative. It reads like a stripped-down version of the column in which Paul Merriman discusses his ultimate buy-and-hold allocation, (I mean this positively) with an emphasis on the Risk versus Return tradeoff.

Regarding the "stripped down version," I agree. With a lot of this stuff, I feel like we most often need to give people a toehold to start climbing up the learning curve.

Also, my general observation is that anytime a vendor (or accountant, attorney, financial engineer, etc) sells something too complicated for the user to understand, one wants to put a hand on one's wallet and slowly back out of the saloon.