What Is Postmodern Portfolio Theory?
Postmodern Portfolio Theory (PMPT) is an advanced approach within portfolio theory that seeks to address perceived limitations of traditional Modern Portfolio Theory (MPT). Unlike MPT, which primarily uses standard deviation as its measure of risk, Postmodern Portfolio Theory focuses specifically on downside risk, acknowledging that investors typically view losses below a target return differently from gains above it. This framework emphasizes that volatility above a desired threshold is generally welcomed, while volatility below that threshold, leading to potential losses, is the true concern for investors. PMPT incorporates elements like investor psychology and the potential for non-normal return distributions to create more tailored investment strategy.
History and Origin
Postmodern Portfolio Theory emerged in response to perceived shortcomings of Modern Portfolio Theory (MPT), particularly its reliance on assumptions such as normally distributed returns and the use of standard deviation, which treats both positive and negative deviations from the mean as equally undesirable. PMPT began to gain prominence in the early 1990s. Brian M. Rom and Kathleen W. Ferguson, principals of software developer Investment Technologies, LLC, are often credited with coining the term "Post-Modern Portfolio Theory" and publishing early influential works on the subject, notably in The Journal of Investing in 1993 and 1994. The theory's underlying concepts, however, had been explored earlier, with empirical investigations into downside risk beginning in the 1980s, driven by researchers like Dr. Frank Sortino and Dr. Hal Forsey at the Pension Research Institute (PRI) at San Francisco State University. PMPT was developed to provide a more nuanced framework for portfolio management, recognizing that investor preferences and behaviors were not always captured by traditional models.6
Key Takeaways
- Postmodern Portfolio Theory (PMPT) emphasizes downside risk, or the risk of returns falling below a specific target, rather than total volatility.
- It acknowledges that investors typically differentiate between "good" volatility (upside gains) and "bad" volatility (downside losses).
- PMPT often employs alternative risk measures like the Sortino Ratio, which isolates unfavorable deviations from a target return.
- The theory aims to build portfolios that better align with an investor's true perception of risk and their specific financial goals.
- PMPT often incorporates elements from behavioral finance, recognizing the psychological impact of losses.
Formula and Calculation
A core component of Postmodern Portfolio Theory is the focus on downside risk and metrics that specifically quantify it. The Sortino Ratio is a prominent risk-adjusted return measure often used within the PMPT framework. Unlike the Sharpe Ratio, which uses total standard deviation, the Sortino Ratio uses downside deviation in its calculation. Downside deviation measures the standard deviation of only those returns that fall below a specified minimum acceptable return (MAR) or target return.
The formula for the Sortino Ratio is:
Where:
- (R_p) = Portfolio's actual expected return
- (MAR) = Minimum Acceptable Return (the target return below which returns are considered "risky")
- (\text{Downside Deviation}) = Standard deviation of returns below the MAR
The Sortino Ratio improves upon traditional measures by differentiating between desirable and undesirable volatility.5
Interpreting the Postmodern Portfolio Theory
Interpreting Postmodern Portfolio Theory involves shifting the focus from simply optimizing for total return versus total risk to optimizing for return in relation to unfavorable outcomes. A portfolio constructed using PMPT principles aims to minimize the probability and magnitude of returns falling below an investor's specific financial objectives, such as a required spending rate or a target retirement fund growth.
When evaluating a portfolio through the lens of PMPT, one would look at measures like the Sortino Ratio, which provides a clearer picture of how much return is generated for each unit of "bad" downside risk taken. A higher Sortino Ratio indicates better risk-adjusted performance from a PMPT perspective, as it implies the portfolio is generating more return above the minimum acceptable threshold for a given level of undesirable volatility. This approach helps align portfolio construction with the real-world concerns of investors, who are often more concerned with wealth preservation and meeting specific liabilities than with maximizing returns regardless of downside exposure. This leads to a more intuitive approach to risk management.
Hypothetical Example
Consider an investor, Sarah, who has a retirement goal requiring an average annual return of at least 5% to meet her future expenses. She is evaluating two hypothetical portfolios, Portfolio A and Portfolio B, both with an average historical return of 8%.
- Portfolio A (MPT-optimized): Has a standard deviation of 12%. This portfolio might be chosen based on MPT for its overall risk-return profile.
- Portfolio B (PMPT-optimized): Has a downside deviation of 6% (relative to Sarah's 5% MAR). This portfolio was designed to minimize the risk of falling below her 5% target.
Using the Sortino Ratio (MAR = 5%):
- Portfolio A (hypothetical Sortino): Let's assume its downside deviation is 9% (due to treating both upside and downside volatility equally).
- Portfolio B (PMPT-optimized):
In this scenario, while both portfolios have the same average return, Portfolio B has a higher Sortino Ratio. This suggests that Portfolio B is more efficient at generating returns above Sarah's 5% minimum acceptable return, relative to the undesirable downside risk it incurs. For Sarah, who prioritizes meeting her specific retirement goal and avoiding losses below it, Portfolio B, optimized using PMPT principles, would be the preferred choice, offering a better risk-adjusted return aligned with her actual concerns.
Practical Applications
Postmodern Portfolio Theory finds several practical applications in the real world of investing, particularly for investors with specific return targets or significant aversion to negative outcomes.
- Pension Fund Management: Institutional investors, such as pension funds, often have clear long-term liabilities and actuarial return requirements. PMPT’s focus on avoiding returns below a specific target makes it highly relevant for optimizing portfolios to meet these obligations, rather than simply maximizing overall return regardless of downside deviations.
*4 Wealth Management for High-Net-Worth Individuals: Advisors often use PMPT to tailor portfolios to individual client psychological profiles, recognizing that high-net-worth individuals may have distinct downside protection concerns or specific wealth transfer goals that require guarding against negative returns more than optimizing for total variance. - Responsible and Sustainable Investing: PMPT principles can be applied to integrating extra-financial factors, such as environmental, social, and governance (ESG) criteria, into investment decisions. By considering these factors, portfolios can be managed to avoid "bad" outcomes (e.g., investing in companies with high litigation risk or environmental liabilities) and thus enhance long-term risk management from a broader perspective.
*3 Hedge Funds and Alternative Investments: Given their often non-normal return distributions and focus on absolute returns, hedge funds and other alternative investments are well-suited to PMPT analysis. Tools like the Sortino Ratio are particularly useful for evaluating their performance, as they effectively capture the risk-return trade-off when returns are skewed.
Limitations and Criticisms
While Postmodern Portfolio Theory offers a valuable refinement to traditional portfolio management, it is not without its limitations and criticisms. One primary criticism revolves around its core measure, the Sortino Ratio, and by extension, the concept of downside deviation. While Sortino's work aims to differentiate between "good" and "bad" volatility, some argue that entirely ignoring upside volatility might be a simplification. As one critique noted, measures like the Sortino Ratio "totally ignore upside risk" and "are generally inaccurate as an appropriate risk and/or performance measure" if the goal is a complete picture of all risk-taking. E2ven the Sortino Ratio, while valuable, "is not a complete measure of risk" and "outperformance should not be ignored because these gains were generated by risk taking; the same strategy might produce corresponding losses at some point in the future."
1Furthermore, the selection of the "minimum acceptable return" (MAR) in PMPT is subjective and can significantly influence portfolio optimization outcomes. If the MAR is set unrealistically high or low, the resulting portfolio may not truly reflect the investor's actual risk tolerance or objectives. While PMPT aims to incorporate aspects of behavioral finance, the quantitative models still rely on historical data to estimate future downside risk, which may not always be indicative of future market conditions or market anomalies. The assumption that investor preferences can be neatly captured by a single MAR, and that all deviations above it are "good," may oversimplify complex human investor psychology and decision-making processes.
Postmodern Portfolio Theory vs. Modern Portfolio Theory
Postmodern Portfolio Theory (PMPT) and Modern Portfolio Theory (MPT) both aim to optimize investment portfolios, but they differ fundamentally in their definitions and measurements of risk.
| Feature | Modern Portfolio Theory (MPT) | Postmodern Portfolio Theory (PMPT) |
|---|---|---|
| Risk Definition | Total volatility, measured by standard deviation (variance). Treats both upside and downside deviations as equally undesirable. | Downside risk, measured by downside deviation. Focuses on returns falling below a specific target. |
| Risk-Return Trade-off | Seeks to maximize expected return for a given level of total risk, or minimize total risk for a given expected return, leading to an efficient frontier. | Seeks to maximize return above a minimum acceptable return (MAR) for a given level of downside risk. |
| Return Distribution | Assumes asset returns follow a normal (symmetrical) distribution. | Acknowledges that asset returns are often non-normally distributed, with skewness and kurtosis. |
| Investor Behavior | Assumes investors are rational and risk-averse, maximizing utility based on mean and variance. | Incorporates insights from behavioral finance, recognizing that investors have asymmetric preferences regarding gains and losses. |
| Key Metrics | Standard Deviation, Beta, Sharpe Ratio. | Downside Deviation, Sortino Ratio, Value at Risk (VaR). |
The core confusion between the two theories arises from the word "risk." MPT views risk as any deviation from the mean, whether positive or negative, because volatility inherently introduces uncertainty. PMPT, however, refines this by stating that only negative deviations or those below a specified goal are truly "risky" or undesirable to the investor. While MPT provides a foundational framework for diversification and asset allocation, PMPT offers a more nuanced, goal-oriented approach to portfolio construction, aiming to better reflect the real-world concerns and psychological biases of investors.
FAQs
How does Postmodern Portfolio Theory account for investor behavior?
Postmodern Portfolio Theory (PMPT) incorporates elements of behavioral finance by recognizing that investors are often more concerned about losing money or failing to meet specific financial goals than they are about positive volatility. It distinguishes between "good" volatility (upside gains) and "bad" volatility (downside losses), aligning the definition of risk with how investors psychologically perceive it.
Can PMPT guarantee higher returns or lower risk?
No, like any financial theory, Postmodern Portfolio Theory cannot guarantee higher returns or lower risk. It provides a framework for managing a portfolio with a specific focus on downside risk relative to a target return. Investment outcomes are always subject to market conditions and other unpredictable factors.
Is Postmodern Portfolio Theory only for sophisticated investors?
While the underlying mathematics can be complex, the principles of Postmodern Portfolio Theory, such as focusing on specific financial goals and minimizing losses below a target, are applicable to all investors. Many financial advisors use these concepts to tailor investment strategy for their clients, even if the clients aren't aware of the formal theory.
What is the Minimum Acceptable Return (MAR)?
The Minimum Acceptable Return (MAR) is a critical component of Postmodern Portfolio Theory. It represents the specific return threshold that an investor deems necessary to achieve their financial objectives. Returns falling below the MAR are considered undesirable and contribute to the portfolio's downside risk.
How does PMPT influence portfolio construction?
PMPT influences portfolio construction by guiding the selection of assets and their asset allocation based on their contribution to downside risk, rather than total volatility. This can lead to portfolios that may look different from those optimized solely by Modern Portfolio Theory, potentially favoring assets or strategies that offer better downside protection or more favorable skewed returns.