![]() ![]() While Modern Portfolio Theory is an important theoretical advance, its application has universally encountered a problem: although the covariances of a few assets can be adequately estimated, it is difficult to come up with reasonable estimates of expected returns.īlack–Litterman overcame this problem by not requiring the user to input estimates of expected return instead it assumes that the initial expected returns are whatever is required so that the equilibrium asset allocation is equal to what we observe in the markets. In principle Modern Portfolio Theory (the mean-variance approach of Markowitz) offers a solution to this problem once the expected returns and covariances of the assets are known. For example, a globally invested pension fund must choose how much to allocate to each major country or region. Asset allocation is the decision faced by an investor who must choose how to allocate their portfolio across a number of asset classes. ![]()
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