Post-Modern Portfolio Theory (PMPT)

What Is the Post-Modern Portfolio Theory (PMPT)?

The 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 the modern portfolio theory (MPT). Both theories describe how risky assets should be valued, 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 the Post-Modern Portfolio Theory (PMPT)

The 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 the MPT and sought to differentiate the portfolio construction software developed by their company, Sponsor-Software Systems Inc.

The theory uses the standard deviation of negative returns as the measure of risk, while the 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, the 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 the 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.

Components of the Post-Modern Portfolio Theory (PMPT)

The differences in risk, as defined by the standard deviation of returns, between the PMPT and the MPT is the key factor in portfolio construction. The MPT assumes symmetrical risk whereas the 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.

Post-Modern Portfolio Theory (PMPT) vs. Modern Portfolio Theory (MPT)

The MPT focuses on creating investment portfolios with assets that are non-correlated; if one asset is negatively impacted in a portfolio, other assets are not necessarily so. This is the idea behind diversification. For example, if an investor has oil stocks and technology stocks in their portfolio and new government regulation on oil companies hurts the profits of oil companies, their stocks will lose value; however, the technology stocks won't be affected. The gains in the tech stocks will offset the losses of the oil stocks.

The MPT is the primary method in which investment portfolios are constructed today. The theory is the basis behind passive investing. There are, however, many investors that seek to increase their returns beyond what passive investing can bring or reduce their risk in a more significant way; or both. This is known as seeking alpha; returns that beat the market, and is the idea behind actively managed portfolios, most often implemented by investment managers, particularly hedge funds. This is where the post-modern portfolio theory comes into play, whereby portfolio managers seek to understand and incorporate negative returns in their portfolio calculations.