The Black-Litterman Model: Wrong Views v.s. Opportunity Cost

Abstract:     
The formulation of the Black-Litterman model as a Bayesian mixed estimation approach allows for computing the posterior expected returns taking into account the views of investor on future returns. When the views turn out to be wrong, the resulting portfolio may lead to losses. Sometimes, it may be better for investor to keep in hands his (her) current allocation instead of following wrong views. However, keep the current allocation in hands suffers from the opportunity cost. In this paper, we develop an extension of the Black-Litterman model for reducing losses when the views of investor turn out to be wrong (or partially true).

Number of Pages in PDF File: 19

Keywords: Black-Litterman, Bayesian Mixed Estimation, Opportunity Cost, Transaction Cost

JEL Classification: G11, G12, C11

working papers series