Behavioral Finance and its Implication in the Use of the Black-Litterman Model
Posted: 22 Jun 2011
Date Written: June 20, 2011
In this article, we discuss the often overlooked behavioral implications of the Black-Litterman model when this portfolio allocation modeling tool is put into practice. One of the most interesting features of this model is that the benchmark portfolio, against which the performance of the portfolio manager is evaluated, functions as the point of reference. In behavioral finance, the actual utility function of the investor is reference-based, and investors estimate losses and gains in relation to this benchmark. Implications drawn from past research within the field indicate and explain why the portfolio output given by the Black-Litterman model appears more intuitive to fund managers than portfolios generated by the Markowitz model. Another feature of the Black-Litterman model is that the user assigns levels of confidence associated with each asset view in the form of confidence intervals. However, studies have shown that people tend to be badly calibrated when estimating their levels of confidence. People are overconfident in financial decision-making, particularly when stating confidence intervals, which is particularly problematic for this model. For a deeper understanding of the use of the Black-Litterman model, we turn to those financial fields in which social and organizational context and issues are taken into consideration.
Keywords: Portfolio Theory, Black-Litterman, Markowitz Allocation, Real Estate
Suggested Citation: Suggested Citation