The Post-Modern Portfolio Theory Uses the Downside Risk of Returns
But first, let us start with the Modern Portfolio Theory by Harry Markowitz.
In 1952, a man named Harry Markowitz received a Nobel Prize because of a theory he created, and it is called the Modern Portfolio theory. According to this theory, it is possible to have a portfolio with more returns while taking the lowest potential risk. Investors can lessen this risk by using a quantitative method for diversification. MTP is a model that helps investors get more returns while taking the least risk. MTP assumes that all investors think the same and that they are risk-averse. It also says that these risks are part of getting a better reward.
Now, let’s talk about the Post-Modern Portfolio Theory.
Post-modern portfolio theory is another methodology that aims to optimize portfolios. It was made by Brian Rom and Kathleen Ferguson from the Sponsor- Software System Inc. Company in 1991. They are both software designers, and they thought that MPT-based software has significant flaws and limitations. Hence, they claim that their PMPT software that also creates a portfolio is considerably different from MPT.
While MPT uses mean-variance of investment returns, PMPT is a methodology that uses downside risk of returns. These methodologies are different in many ways, but they have some similarities. They state that risky assets should be valued, and rational investors should make the most of diversification to have a better portfolio. However, these two theories do not agree on their definition of risk, influencing expected returns.
Diving deeper into the Post-Modern Portfolio Theory
In 1952, the MPT received the Nobel Prize. For many decades, it became the most common way of thinking when it comes to portfolio management. Until now, there are still financial managers who use MPT. However, Rom and Ferguson would beg to disagree on this. They stressed that MPT has significant limitations:
- The assumptions that all portfolios’ and securities’ revenue returns can be represented by joint elliptical distribution like the normal distribution, accurately.
- The proper measure of investment risk is the variance of the portfolio.
These are the limitations that Rom and Ferguson aim to refine. In 1993, they introduced PMPT in The Journal of Performance Management. PMPT continues to improve and expand as people, and even academics worldwide tested both MPT and PMPT. They realized and proved that both of them are valuable.
What makes up the Post-Modern Portfolio Theory?
The differences in risks between the MPT and PMPT is the most significant factor in making a portfolio. While MPT assumes the symmetrical risk, PMPT assumes asymmetrical ones. Target semi-deviation measures downside risks called downside deviation. It eliminates the negatives returns.
While MPT uses the Sharpe ratio to measure risk-adjusted return, PMPT uses the Sortino ratio. The second statistic that will analyze portfolios and will be added to the PMPT rubric is called “volatility skewness.” It measures a distribution’s percentage ratio of the total variance from the return above the mean to those below the mean.
A quick recap
The PMPT uses the downside risk of return to optimize portfolios. MPT and PMPT stress the importance of risky assets and diversification. They differ in their definitions of risk and how it affects returns. Rom and Ferguson believed that MPT has flaws and limitations. MPT’s measure of risk is the standard deviation of all returns while PMPT uses the standard deviation of negative returns. PMPT replaced MPT’s Sharpe ratio with the Sortino ratio.