Black-Litterman model
Quantitative Finance glossary · Quantitative Finance
Definition
Bayesian portfolio construction combining a prior of equilibrium (market-implied) expected returns boldsymbolPi — obtained by reverse-optimisation boldsymbolPi = γ,boldsymbolΣ,boldsymbolw_mkt — with investor views boldsymbolPboldsymbolμ = boldsymbolQ + boldsymbolvarepsilon to produce a posterior boldsymbolμ_BL = [(τboldsymbolΣ)^-1 + boldsymbolP^TboldsymbolΩ^-1boldsymbolP]^-1,[(τboldsymbolΣ)^-1boldsymbolPi + boldsymbolP^TboldsymbolΩ^-1boldsymbolQ]. Solves Markowitz's notorious corner-solution / input-sensitivity problem by anchoring to equilibrium and only tilting where the investor has high conviction.
Black-Litterman model in plain English
The Black-Litterman model is a smart recipe for deciding how to split your money across investments. Plain mean-variance math tends to give crazy, extreme answers that flip wildly if you nudge your guesses — so this model starts from a sensible default (what the whole market's current prices quietly imply everyone expects) and then only nudges away from it where you personally have a strong opinion, and only as hard as your confidence justifies. It's like starting an essay from a solid template instead of a blank page: you keep the reliable structure and only rewrite the parts where you actually have something to add. The result is a portfolio that's stable and reasonable instead of jumpy and overconfident.
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