What is 'Post-Modern Portfolio Theory - PMPT'

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.

BREAKING DOWN '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.

RELATED TERMS
  1. Expectations Theory

    The expectations theory uses long-term interest rates to forecast ...
  2. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the ...
  3. Harry Markowitz

    Harry Markowitz is a Nobel Memorial Prize winning economist who ...
  4. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  5. Risk Management

    Risk management occurs anytime an investor or fund manager analyzes ...
  6. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
Related Articles
  1. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  2. Financial Advisor

    Example of Applying Modern Portfolio Theory (MPS)

    See how an investor can maximize expected return for a given level of risk by altering the proportions of the assets held.
  3. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  4. Investing

    Beware Of Wall Street's Three Big Lies

    Don't get swindled into buying snake oil from Wall Street. Find out three lies that can lead to losing investments.
  5. Investing

    Understanding The Sharpe Ratio

    The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.
  6. Investing

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  7. Investing

    How to Create a Low-Risk, High-Return Portfolio

    Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
  8. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  9. Investing

    Mitigating Downside With the Sortino Ratio

    Differentiate between good and bad volatility with the Sortino ratio.
  10. Investing

    5 Ways to Rate Your Portfolio Manager

    These five performance ratios will help you measure how good your money manager is at increasing the value of your portfolio.
RELATED FAQS
  1. What's the difference between agency theory and stakeholder theory?

    Agency theory and stakeholder theory are both used to understand and explain various types of relationships and challenges ... Read Answer >>
  2. What is the difference between standard deviation and average deviation?

    Understand the basics of standard deviation and average deviation, including how each is calculated and why standard deviation ... Read Answer >>
  3. What is the difference between standard deviation and variance?

    Understand the difference between standard deviation and variance; learn how each is calculated and how these concepts are ... Read Answer >>
  4. How do a Sharpe ratio and an information ratio differ?

    The Sharpe ratio and the information ratio are both tools used to evaluate the risk-adjusted rate of return of an investment ... Read Answer >>
  5. How is covariance used in portfolio theory?

    Learn how covariance is used to reduce risk in modern portfolio theory, how covariance is calculated and how it is used to ... Read Answer >>
Trading Center