What Is Post-Modern Portfolio Theory?
Post-Modern Portfolio Theory (PMPT) is a portfolio optimization methodology that uses the downside risk of returns instead of the mean variance of investment returns used by modern portfolio theory (MPT). Both theories describe how risky assets should be valuated, and how rational investors should utilize diversification to achieve portfolio optimization. The difference lies in each theory's definition of risk, and how that risk influences expected returns.
Understanding Post-Modern Portfolio Theory (PMPT)
PMPT was conceived in 1991 when software designers Brian M. Rom and Kathleen Ferguson perceived there to be significant flaws and limitations with software based on MPT and sought to differentiate the portfolio construction software developed by their company, Investment Technologies. The theory uses the standard deviation of negative returns as the measure of risk, while modern portfolio theory uses the standard deviation of all returns as a measure of risk. After economist Harry Markowitz pioneered the concept of MPT in 1952, later winning the Nobel Prize for Economics for his work centered on the establishment of a formal quantitative risk and return framework for making investment decisions, MPT remained the primary school of thought on portfolio management for many decades and it continues to be utilized by financial managers.
Rom and Ferguson noted two important limitations of MPT: its assumptions that the investment returns of all portfolios and securities can be accurately represented by a joint elliptical distribution, such as the normal distribution, and that the variance of portfolio returns is the right measure of investment risk. Rom and Ferguson then refined and introduced their theory of PMPT in a 1993 article in The Journal of Performance Management. PMPT has continued to evolve and expand as academics worldwide have tested these theories and verified that they have merit.
The Elements of PMPT
The differences in risk, as defined by the standard deviation of returns, between PMPT and MPT is the key factor in portfolio construction. MPT assumes symmetrical risk whereas PMPT assumes asymmetrical risk. Downside risk is measured by target semi-deviation, termed downside deviation, and captures what investors fear most: having negative returns.
The Sortino ratio was the first new element introduced into the PMPT rubric by Rom and Ferguson, which was designed to replace MPT’s Sharpe ratio as a measure of risk-adjusted return, and improved upon its ability to rank investment results. Volatility skewness, which measures the ratio of a distribution’s percentage of total variance from returns above the mean to the returns below the mean, was the second portfolio-analysis statistic to be added to the PMPT rubric.