AllocationADVISOR

Black-Litterman

What should I input for palette risk premium?

The forward looking Risk Premium is one of the most contentious topics in finance. The equity Risk Premium is the expected excess return of equity over the Risk-Free Rate. For the calculation of the Implied Returns, the Risk Premium is an estimate of the Asset Palette’s excess return over the Risk-Free Rate. The Asset Palette Risk Premium acts as a scaling factor in the reverse optimization process.

We strongly encourage you to use your own estimate of the Risk Premium based on your estimate of the “market’s” expected excess return over the Risk-Free Rate where the “market” is defined by the market capitalizations of the asset classes that you are optimizing. We have included possible values in AllocationADVISOR for those who need guidance, but they may not match your market portfolio exactly. You should enter your best estimate of the excess return of your market portfolio over the risk-free rate.

While we recommend that you select a reasonable number, the actual number (assuming it is positive) will not change the composition of the efficient allocations that form the efficient frontier. What is affected by the Risk Premium is the magnitude of the return forecasts. An unrealistic Risk Premium results in unrealistic forecast returns leading to unrealistic conclusions regarding future wealth.

Should one use short term cash rates for the risk free rate? Does this depend on the time horizon?

The majority of academics use the yield on a longer-term bond (usually the 10-year US Treasury Bond) to estimate the Risk-Free Rate. This is because most investors have a fairly long investment horizon when developing a strategic asset allocation. Over a ten year investment horizon, the most certain cash flows are those from a ten-year US Treasury Bond.

Why does Black-Litterman use equilibrium return forecasts but historical standard deviations and correlations?

The Black-Litterman model was developed to overcome the biggest flaw in mean-variance optimization--it's sensitivity to the expected return forecasts. Using historical forecasts of expected returns lead to poorly diversified and unintuitive portfolios. Black-Litterman uses the historical standard deviations and correlations because their values tend to be stable and to make good forecasts. AllocationADVISOR does allow users to override the standard deviations and correlations with your own estimates.