Postmodern 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). PMPT was conceived in 1991 when software designers Brian M. Rom and Kathleen Ferguson realized that there were significant flaws and limitations in MPT-based software and attempted to differentiate the portfolio construction software developed by their company, Sponsor-Software Systems. Inc. Let's see what postmodern portfolio theory is based on.
What is postmodern portfolio theory?
Postmodern 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 valued and how rational investors should use diversification to achieve portfolio optimization. The difference lies in each theory's definition of risk and how that risk influences expected returns.
What is postmodern portfolio theory for?
PMPT was conceived in 1991 when software designers Brian M. Rom and Kathleen Ferguson realized that there were significant flaws and limitations in MPT-based software and attempted to differentiate the portfolio construction software developed by their company, Sponsor-Software Systems. Inc. theory uses the standard deviation of negative returns as a 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 in Economics for his work focused on establishing a formal quantitative risk-return framework for making investment decisions, MPT continued. remains the leading school of thought on portfolio management for many decades and continues to be used by financial managers.
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Components of postmodern portfolio theory
The risk differences, defined by the standard deviation of returns, between the PMPT and the MPT are the key factor in portfolio construction. The MPT assumes symmetric risk, while the PMPT assumes asymmetric risk. Downside risk is measured by the target semi-deviation, called 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 the MPT's Sharpe ratio as a measure of risk-adjusted returns, and improved its ability to classify investment outcomes. Volatility skewness, which measures the relationship between the percentage of total variance of a distribution of returns above the mean and returns below the mean, was the second portfolio analysis statistic added to the PMPT rubric .