As just explained, Black and Litterman (1999) ask what equilibrium returns are consistent with modern portfolio theory (MPT) and the capitalization weights found in the marketplace. Investors often want to address a different question: what return can be expected from a portfolio chosen by the investor (rather than a market-weighted portfolio)? And what is the standard deviation of that portfolio? To answer those questions, it’s necessary to provide estimates of the expected returns on the individual assets in the portfolio. And it’s necessary to provide estimates of the standard deviations and correlations for the assets in the portfolio. The investor could begin with the equilibrium returns estimated using Black-Litterman methods, but these returns might be at sharp variance with historical returns.

Consider first a portfolio consisting of the basic capital market assets, stocks and bonds. Earlier in the chapter, Figure 8.2 showed an efficient frontier defined by these two assets where SBBI’s large-cap U.S. stocks and U.S. Treasury bonds represented stocks and bonds, respectively. Figure 8.2 was based on actual historical returns measured in nominal terms over the period from 1951 through 2009. Average stock returns exceeded 11 percent and average bond returns exceeded 6 percent over this period. In Chapter 2, however, we argued that real returns provided a firmer basis for calculating expected returns. The investor is ultimately ...

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