A Look at the Post Modern Portfolio Theory

The modern portfolio theory (MPT) was first developed in the 1920s to estimate the value of a portfolio based on its diversification. The MPT is an actual mathematical algorithm showing that a diversified portfolio is less risky than any individual investment. Further, it aims to appropriately balance this risk so the portfolio has the greatest potential reward for each incremental increase in risk. While the MPT was long believed to be a breakthrough theory, and its creator even won a Nobel Prize, it has been replaced with the "post modern portfolio theory" (PMPT) for a number of reasons.

Limitations of the MPT

There are a number of limitations on the effectiveness for the MPT to measure risk and reward of a portfolio. First, the theory operates under the hypothesis that variance is the best measure of risk for an investment. Variance is a measure of how much a security will move up and down from a central mean. A highly variable security is considered to be highly risky because of its unpredictability. However, unpredictability and risk are not necessarily correlated. The MPT also falls short in its assumption that a portfolio's joint elliptical distribution is representative of the profits on all its individual securities. In fact, an outlier can greatly reduce the ability for a single curve to represent the viability and risk of a portfolio. By using different measurements, the affect of outliers can be reduced.

Factors Used in the PMPT

To overcome the shortfalls of the MPT, The Pension Research Institute at San Francisco State University took on a new matrix. This matrix included several factors to measure the risk and reward of a complete portfolio. Those factors include:

  • Downside risk - The downside risk of any investment is how much the investor could lose if the market turned. This is a "worst-case scenario" formula.
  • Sortino ratio - This is a modification on the long-used Sharpe ratio to measure volatility. In the denominator of the ratio, the Sortino ratio uses downside deviation rather than standard deviation. This means the ratio does not account for volatility in the upward direction but only uses volatility in the downward direction to show risk.
  • Volatility skew - This is a measure of the difference of volatility on an options contract. It measures the difference between "out-of-the-money," "at-the-money" and "in-the-money" strikes. When volatility is skewed, it decreases as the strike price rises. This occurs because the manager of a portfolio writes more calls than puts on options.

Modern Application of the PMPT

As a common investor, you are not likely to use the algorithm for the PMPT in any of your investment decisions. This measurement is highly complicated, and it is mostly used by analysts to describe the way a portfolio can reduce risk. By using these findings, you can attempt to properly diversify your portfolio to reduce your risk on the whole while maximizing your reward. However, you must rely on your investment analyst to understand the algorithm and apply it to your portfolio when recommending investment opportunities to you. Otherwise, you will need a complicated financial calculator and a lot of time to spend analyzing your options.

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