Modern Asset Allocation Modeling
For these and similar reasons, many advisors have jettisoned the traditional approach and moved to an approach championed by Fischer Black and Robert Litterman (known as the Black-Litterman model).23 Black-Litterman is an alternative method for estimating the inputs needed for portfolio optimization. Instead of estimating forward-looking risks, returns, and correlations, Black-Litterman relies on equilibrium models to determine the inputs.
Thus, Black-Litterman lets the markets themselves tell us what returns are, creating a market equilibrium portfolio using capital asset pricing model (CAPM) techniques. Black-Litterman presupposes that if everyone in the market had the same views about valuations, the demand for various assets would exactly equal their supply. Thus, global market capitalizations tell us what we need to know about returns, except for the process of applying our own views to that mix. As Black and Litterman put it in their original paper, “Our approach allows us to generate optimal portfolios that start at a set of neutral weights and then tilt in the direction of the investor's views.”24
An example of this tilt would be to compare (for example) Robert Shiller's CAPE (cyclically adjusted price-earnings) ratio to current P/Es. The Shiller P/Es are “normalized” by dividing the real (i.e., inflation-adjusted) price level of the S&P 500 index by the moving average of the preceding 10 years of real reported returns by S&P companies.25 At the time of this writing, current P/Es seem reasonable, at about 15x. But CAPE suggests that on a normalized basis, P/Es are actually well above 20x. Because the long-term average for normalized P/Es is about 16x, this suggests that stocks may in fact be well overvalued.
Whether stocks are cheap or expensive can't be known in advance, but an investor or its advisor will likely have an opinion, and that opinion, using the Black-Litterman approach, will drive the stock allocation in the investor's asset allocation strategy.
Using Black-Litterman to design portfolios represents a very large advance over older approaches, but it should also be said that Black-Letterman isn't for sissies. For many years after the approach was first proposed—and many articles written about it—it was still maddeningly difficult to figure out how to design a real-world portfolio using Black-Litterman techniques.
Fortunately, Thomas M. Idzorek, of Ibbotson Associates, has authored “A Step-by-Step Guide to the Black-Litterman Model.”26 It's recommended reading for any firm wishing to migrate from traditional asset allocation models to a more sophisticated model.