Comparisons between the Markowitz Model and the Black–Litterman Model

Model risk is critical in constructing a portfolio. To avoid model risk, the Black–Litterman model is an approach that allows to adjust the original estimated parameters using the implied market equilibrium returns and investors’ views (Black and Litterman, 1991). This chapter contrasts the standard approach of Markowitz (1952) with the Black–Litterman model and reviews different investment philosophies by Longo (2021). For empirical demonstrations, we consider a predictive regression to form investors’ views, where asset returns are regressed against their lagged values and the market return. Motivated by stylized features of historical returns, we employ heteroscedastic time-series models. Empirical analysis using five industry indexes in the Taiwan stock market shows that the proposed Black–Litterman portfolio outperforms the 1/N portfolio and Markowitz portfolio.