What Is Post Modern Portfolio Theory?
Post-modern portfolio theory (PMPT) is an advanced methodology within portfolio theory that seeks to address the limitations of traditional Modern Portfolio Theory (MPT) by redefining and measuring investment risk in a more nuanced way. Unlike MPT, which considers both upside and downside volatility as risk, post-modern portfolio theory primarily focuses on downside risk—the possibility of returns falling below a predetermined minimum acceptable return. This shift acknowledges that investors are often more concerned with potential losses than with volatility that results in greater-than-expected gains. The theory integrates concepts of investor psychology and decision-making, recognizing that investors are not always perfectly rational. PMPT aims for portfolio optimization that aligns more closely with real-world risk aversion and individual investment goals.
History and Origin
The conceptual underpinnings of post-modern portfolio theory emerged from growing dissatisfaction with certain assumptions of Modern Portfolio Theory, particularly its reliance on symmetric risk measures like standard deviation and the assumption of normally distributed returns. While the foundational work of Harry Markowitz in MPT in the 1950s revolutionized investment management, practitioners noted that its definition of risk did not always align with investors' intuitive understanding—that risk is primarily about losing money.
The earliest published literature under the post-modern portfolio theory rubric was authored by Brian M. Rom and Kathleen W. Ferguson, principals of software developer Investment Technologies, LLC. They are credited with creating PMPT in 1991, identifying flaws in software design using MPT. Their work, published in The Journal of Investing in the early 1990s, aimed to provide analytical methods for investors to optimize their portfolios by focusing on downside risk, distinguishing it from overall volatility. Thi10s development was influenced by earlier academic work on downside risk measures, seeking to apply these concepts to practical portfolio management.
Key Takeaways
- Post-modern portfolio theory (PMPT) redefines risk as downside volatility—the chance of returns falling below a target.
- It contrasts with Modern Portfolio Theory (MPT), which treats all volatility (both upside and downside) as risk.
- PMPT incorporates investor-specific goals and preferences, acknowledging that not all volatility is undesirable.
- Key measures in PMPT include Sortino Ratio and downside deviation, focusing on negative returns.
- The theory aims for more realistic risk management and tailored asset allocation strategies.
Interpreting Post Modern Portfolio Theory
Interpreting post-modern portfolio theory involves understanding that its primary objective is to build portfolios that minimize the risk of failing to meet specific investment objectives, rather than simply minimizing overall portfolio variance. In this framework, a portfolio's performance is often evaluated based on its ability to achieve a minimum acceptable return (MAR) or a target return, with any deviation below this target considered true risk.
For example, measures like the Sortino Ratio are used to assess risk-adjusted returns by considering only downside deviation relative to a target return, in contrast to the Sharpe Ratio, which uses standard deviation of all returns. This allows investors to gauge how well a portfolio manages the specific risk they care about most: the risk of losing money or underperforming a crucial benchmark. By focusing on downside risk, PMPT helps investors create portfolios that align with their personal risk tolerance and financial goals, reflecting that positive volatility is generally welcomed.
Hypothetical Example
Consider an investor, Sarah, who has a clear financial goal: she needs her investment portfolio to achieve at least a 5% annual return to fund her child's college education. She is less concerned with upside volatility (returns significantly above 5%) but is highly sensitive to returns falling below this 5% threshold.
Under a post-modern portfolio theory approach, Sarah's financial advisor would focus on constructing a portfolio that minimizes the likelihood of returns falling below 5%. They might analyze different assets based on their historical downside deviation relative to a 5% target. For instance, Asset A might have an average return of 8% with a downside deviation of 2% below 5%, while Asset B has an average return of 7% with a downside deviation of 1.5% below 5%. Even though Asset A has a higher average return, Asset B might be preferred under PMPT if its lower downside deviation provides greater assurance of meeting the 5% target. This focus allows Sarah to pursue an investment strategy specifically tailored to her crucial objective, rather than simply seeking the highest possible return for a given level of total volatility.
Practical Applications
Post-modern portfolio theory finds several practical applications in investment management, particularly for investors with specific financial goals or those highly sensitive to losses.
One key application is in goal-based investing, where portfolios are constructed to meet predefined financial targets, such as retirement income, education funding, or specific liabilities. By focusing on downside risk relative to these goals, PMPT helps structure portfolios that prioritize the probability of success.
Anot9her area is performance measurement and attribution. Metrics like the Sortino Ratio are particularly useful for evaluating fund managers, as they reward managers for generating returns above a target while penalizing them for downside volatility. This contrasts with traditional measures that might penalize any volatility, even if it leads to greater upside.
Furthermore, PMPT is applied in asset liability management, especially for pension funds or endowments that have specific future obligations. The theory helps these institutions manage the risk of not having sufficient assets to meet their liabilities. Finally, it can inform risk budgeting frameworks, allowing institutions and individuals to allocate risk more precisely where it matters most—the risk of underperforming critical thresholds. The Sortino Ratio, a key measure in PMPT, helps investors assess risk-adjusted returns by focusing on downside deviation, providing a more intuitive measure of risk for many. [Morningstar]
Limitations and Criticisms
While post-modern portfolio theory offers valuable insights by focusing on downside risk, it is not without its limitations and criticisms. One challenge lies in the complexity of calculation and implementation compared to traditional MPT. Identifying and consistently measuring "minimum acceptable returns" or target returns can be subjective and vary greatly among investors, leading to an infinite number of "efficient frontiers" rather than a single, easily quantifiable one.
Anothe8r criticism is the data intensity required. Accurate measurement of downside deviation and other PMPT metrics often necessitates more granular historical data and sophisticated statistical techniques, which may not always be readily available or computationally feasible for all investors. Critics also argue that while PMPT addresses the "bad" volatility, it might still rely on historical data to predict future performance, which is an inherent limitation of any quantitative investment model.
Furthe7rmore, the emphasis on downside risk, while intuitive, might sometimes lead to overlooking potentially beneficial investment opportunities that exhibit higher overall volatility but also significant upside potential. It also doesn't fully capture the breadth of behavioral biases that influence investor decisions, even though it acknowledges investor irrationality. The broader field of cognitive biases and their impact on market behavior continues to evolve beyond just downside sensitivity.
Pos6t Modern Portfolio Theory vs. Behavioral Finance
Post-modern portfolio theory and behavioral finance are both responses to the limitations of traditional finance theories, particularly Modern Portfolio Theory, but they address these limitations from different angles.
Post-modern portfolio theory primarily focuses on refining the definition and measurement of risk. Its core innovation is replacing standard deviation as a risk measure with downside deviation, focusing on the volatility of returns below a target. This acknowledges that investors view upside volatility (returns above expectation) differently from downside volatility (returns below expectation). While it implicitly recognizes that investor preferences influence what constitutes "risk," its methodology remains largely quantitative and focused on portfolio construction.
Behavioral finance, on the other hand, delves deeper into the psychological and emotional factors that influence investor behavior and market anomalies. It challenges the assumption of perfectly rational investors and efficient markets, demonstrating how cognitive biases, heuristics, and emotions lead to irrational financial decisions and market inefficiencies. Pioneer5ed by psychologists Daniel Kahneman and Amos Tversky in the late 1970s, behavioral finance seeks to understand why investors deviate from rational choices.
While 4post-modern portfolio theory makes adjustments to quantitative models based on a more realistic understanding of risk perception, behavioral finance offers a broader framework for understanding the human element in financial markets, explaining the underlying causes of investor behavior. PMPT can be seen as incorporating a specific behavioral insight (loss aversion/downside sensitivity) into its quantitative framework, whereas behavioral finance provides a comprehensive study of investor psychology and its pervasive impact on financial markets.
FAQs
What is the main difference between Modern Portfolio Theory (MPT) and Post Modern Portfolio Theory (PMPT)?
The main difference lies in how they define and measure risk. MPT considers all volatility (upside and downside deviations from the mean) as risk, using standard deviation. PMPT, however, defines risk as only downside volatility—returns falling below a specified minimum acceptable return (MAR) or target.
Why 3was Post Modern Portfolio Theory developed?
PMPT was developed to address perceived flaws in MPT, particularly its assumption of normally distributed returns and its symmetrical treatment of risk. Investors often feel that only negative deviations or losses constitute true risk, not positive volatility. PMPT provides a framework that aligns better with this intuitive understanding of risk.
What2 is downside risk in the context of PMPT?
Downside risk in PMPT refers specifically to the volatility of returns that fall below a certain investor-defined threshold or minimum acceptable return. It differentiates between undesirable volatility (losses) and desirable volatility (gains). This focus helps investors prioritize capital preservation and goal attainment.
Does1 PMPT completely replace MPT?
No, PMPT does not completely replace MPT. Instead, it is often viewed as an extension or refinement of MPT. MPT laid foundational principles for diversification and efficient frontier concepts that remain relevant. PMPT builds upon these by offering a more precise and investor-centric approach to risk measurement, particularly for those focused on meeting specific financial objectives.