Understanding Post-Modern Portfolio Theory (PMPT): Explanation and Mechanisms
What Is the Post-Modern Portfolio Theory (PMPT)?
When it comes to optimizing portfolios, the post-modern portfolio theory (PMPT) offers a unique approach. Unlike the traditional modern portfolio theory (MPT), which focuses on mean variance of investment returns, PMPT emphasizes the downside risk of returns. Both theories are essential for guiding how risky assets are valued and how diversification can lead to optimized portfolios. The defining factor between the two lies in their interpretation of risk and its impact on expected returns.
### Key Takeaways
– The Post-modern portfolio theory (PMPT) optimizes portfolios through a downside risk approach.
– PMPT contrasts with MPT by redefining how risk is perceived and its influence on returns.
– In 1991, PMPT was introduced by software designers Brian M. Rom and Kathleen Ferguson to address perceived flaws in MPT’s software design.
– Risk measurement differs as PMPT uses negative returns’ standard deviation, unlike MPT that looks at all returns’ standard deviation.
– The Sortino ratio in PMPT replaces MPT’s Sharpe ratio, enhancing risk-adjusted return evaluation.
Understanding the Post-Modern Portfolio Theory (PMPT)
In 1991, the post-modern portfolio theory (PMPT) was born out of Brian M. Rom and Kathleen Ferguson’s recognition of limitations within the software designed based on the modern portfolio theory (MPT). They sought a more accurate and sophisticated portfolio construction software for their company, Sponsor-Software Systems Inc.
While MPT, introduced by economist Harry Markowitz in 1952, won a Nobel Prize, PMPT challenged the assumptions underlying MPT. Notably, PMPT emphasizes asymmetrical risk, unlike MPT’s symmetrical risk assumption. These distinctions laid the groundwork for a new era in portfolio management.
The limitations of MPT were underscored by Rom and Ferguson, particularly around the accurate representation of portfolio and security returns and the choice of risk measurement. These critiques led to the development and refinement of PMPT, which gained recognition through academic validation worldwide.
Components of the Post-Modern Portfolio Theory (PMPT)
The cornerstone of post-modern portfolio theory (PMPT) lies in its approach to risk quantification. Unlike the modern portfolio theory (MPT) which assumes symmetrical risk, PMPT acknowledges asymmetrical risk through its measurement of downside risk using target semi-deviation. By capturing investors’ concerns about negative returns, PMPT offers a nuanced perspective on risk assessment.
The evolution of PMPT introduced innovative elements such as the Sortino ratio to evaluate risk-adjusted return, surpassing the conventional Sharpe ratio. Additionally, volatility skewness was integrated into PMPT’s framework to enhance portfolio analysis capabilities. These advancements have propelled PMPT into a prominent position in modern portfolio management strategies.
Post-Modern Portfolio Theory (PMPT) vs. Modern Portfolio Theory (MPT)
Modern Portfolio Theory (MPT) lays the foundation for constructing investment portfolios by emphasizing asset diversification to mitigate risk. The concept of non-correlated assets forming a portfolio shields investors from extreme losses in any single asset. On the contrary, post-modern portfolio theory (PMPT) delves into understanding and incorporating negative returns within portfolio strategies, catering to a more nuanced risk perception.
While MPT remains widely adopted for passive investing, some investors seek higher returns or greater risk reduction, a pursuit known as seeking alpha, which actively managed portfolios aim to achieve. This is where PMPT shines, offering a refined framework for portfolio managers to navigate the complexities of negative returns and optimize their investment strategies accordingly.
