Optimizing Portfolio Risk through Diversification: Application of The Black-Litterman Model

Abstract

Aim: The study investigates how the risk reduction strength of different assets and their impact on minimizing portfolio risk. It seeks to recommend an optimal investment strategy using the Black-Litterman model to balance risk and return, helping investors make informed decisions to enhance portfolio stability and financial resilience. Study Design: We adopt a quantitative approach, by employing the Black-Litterman model to analyze portfolio risk reduction. Monthly financial data from 2018 to 2022 is used to evaluate the impact of asset allocation on risk minimization, focusing on assessing various asset combinations to determine the most effective diversification strategy. Place and Duration of Study: The study took place at the Department of Mathematical Sciences, Adekunle Ajasin University, Akungba Akoko, Nigeria, where we explored data from Yahoo finance of Gold, Oil and Gas which span from 2018 to 2022. Methodology: Data from Yahoo Finance (2018-2022) covering Gold, Oil, and Natural Gas was analyzed. The Black-Litterman model was used to compute portfolio risk. The Augmented Dickey Fuller test verified stationary conditions of time series data before the model implementation. Mean-variance optimization techniques determined asset allocation. Various portfolios were compared to identify those with the lowest risk levels. Results: Gold exhibited the highest risk reduction strength (8.7%), followed by oil (8.37%) and natural gas (0.47%). Portfolios containing gold had significantly lower risk levels. The benchmark portfolio had 0.0038 risk, while portfolios excluding gold had higher risks, confirming gold’s effectiveness in minimizing overall portfolio risk. Conclusion: The study confirms that diversification alone does not guarantee risk minimization unless optimal asset selection is applied. Portfolios with high-risk reduction assets like gold significantly lower overall risk. Investors should prioritize assets with strong risk reduction capabilities to enhance portfolio stability, particularly during economic downturns or financial crises.