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1School of Management, University of San Francisco, San Francisco, USA 2Department of Economics, Konkuk University, Seoul, Korea Email: [email protected], [email protected] Received December 19, 2012; revised January 22, 2013; accepted February 6, 2013 Keywords: Black-Litterman; Bayes Rule; Portfolio Construction; Econometric Techniques; Simulations ABSTRACT The Black-Litterman model has gained popularity in applications in the area of quantitative equity portfolio management. Unfortunately, many recent applications of the Black-Litterman to novel aspects of quantitative portfolio management have neglected the rigor of the original Black-Litterman modelling. In this article, we critically examine some of these applications from a Bayesian perspective. We identify three reasons why these applications may create losses to investors. These three reasons are: 1) Using a prior without “anchoring” the prior to an equilibrium model; 2) Using a prior and an equilibrium model that conflict with one another; and 3) Ignoring the implications of the estimation error of the variance-covariance matrix.
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