Extreme Events – Specimen Question A.6.2(c) – Answer/Hints

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Q. Making plausible assumptions about this additional information, suggest a suitable asset allocation for this portfolio. Ideally create a spreadsheet that takes this information as an input and selects the most suitable asset allocation given this information.

There is no real way to make plausible assumptions about the additional information set out in A.6.2(b), except to note that, for example:

i.         The degree of credibility to give to the market in effect corresponds to how large should be the adjustment to the implied alphas for a unit sized investment view. The conventional way of applying Black-Litterman is to identify suitable return assumptions that result in the ‘market portfolio’ being efficient. These assumptions are usually framed so that the spread of mean returns is broadly in line with the spread of long-term average returns seen in practice, e.g. perhaps a c. 3-5% difference between the expected return for the lower returning asset class and that for the highest returning asset class. Although no scale is given for the views in the question, we might implicitly assume that +1 or -1 corresponded to a strong view, e.g. perhaps a view similar in magnitude to this range; and

ii.       The Black-Littermann approach is most usually applied to equity portfolios. A suitable default value for  (the risk/reward trade-off) might be one that corresponds to a portfolio that expresses approximately the same overall risk (versus the minimum risk position) as the ‘market’ portfolio.

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