Post-modern portfolio theory
Encyclopedia
Post-modern portfolio theory (or "PMPT") is an extension of the traditional modern portfolio theory
(“MPT”, which is an application of mean-variance analysis or “MVA”). Both theories propose how rational investors should use diversification to optimize their portfolios, and how a risky asset should be priced.
What has come to be known as Post Modern Portfolio Theory (PMPT) has no single author. It combines the theoretical research of many authors and has expanded over several decades as academics at universities in many countries tested these theories to determine whether or not they had merit. The essential difference between PMPT and the modern portfolio theory of Markowitz and Sharpe (MPT) is that PMPT focuses on the return that must be earned on the assets in a portfolio in order to meet some future payout. This internal rate of return (IRR) is the link between assets and liabilities. PMPT measures risk and reward relative to this IRR while MPT ignores this IRR and measures risk as dispersion about the mean or average return. The result is substantially different portfolio constructions.
Empirical investigations began in 1981 at the Pension Research Institute (PRI) at San Francisco State University. Dr. Hal Forsey and Dr. Frank Sortino were trying to apply Peter Fishburn’s theory published in 1977 to Pension Fund Management. The result was an asset allocation model that PRI licensed Brian Rom to market in 1988. Mr. Rom heard someone at a conference use the term PMPT and began to use the term to market PRI’s allocation model. Sortino and Steven Satchell at Cambridge University co-authored the first book on PMPT. This was intended as a graduate seminar text in portfolio management. A more recent book by Sortino was written for practitioners. The first publication in a major journal was co-authored by Sortino and Dr. Robert van der Meer, then at Shell Oil Netherlands. The concept was popularized by numerous articles by Sortino in Pensions and Investments magazine. Videos, books and papers on PMPT can be found at http://www.sortinodtr.com. Sortino’s current comments regarding PMPT are found at http://pmpt.wordpress.com.
Sortino claims the major contributors to the underlying theory are:
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
(“MPT”, which is an application of mean-variance analysis or “MVA”). Both theories propose how rational investors should use diversification to optimize their portfolios, and how a risky asset should be priced.
What has come to be known as Post Modern Portfolio Theory (PMPT) has no single author. It combines the theoretical research of many authors and has expanded over several decades as academics at universities in many countries tested these theories to determine whether or not they had merit. The essential difference between PMPT and the modern portfolio theory of Markowitz and Sharpe (MPT) is that PMPT focuses on the return that must be earned on the assets in a portfolio in order to meet some future payout. This internal rate of return (IRR) is the link between assets and liabilities. PMPT measures risk and reward relative to this IRR while MPT ignores this IRR and measures risk as dispersion about the mean or average return. The result is substantially different portfolio constructions.
Empirical investigations began in 1981 at the Pension Research Institute (PRI) at San Francisco State University. Dr. Hal Forsey and Dr. Frank Sortino were trying to apply Peter Fishburn’s theory published in 1977 to Pension Fund Management. The result was an asset allocation model that PRI licensed Brian Rom to market in 1988. Mr. Rom heard someone at a conference use the term PMPT and began to use the term to market PRI’s allocation model. Sortino and Steven Satchell at Cambridge University co-authored the first book on PMPT. This was intended as a graduate seminar text in portfolio management. A more recent book by Sortino was written for practitioners. The first publication in a major journal was co-authored by Sortino and Dr. Robert van der Meer, then at Shell Oil Netherlands. The concept was popularized by numerous articles by Sortino in Pensions and Investments magazine. Videos, books and papers on PMPT can be found at http://www.sortinodtr.com. Sortino’s current comments regarding PMPT are found at http://pmpt.wordpress.com.
Sortino claims the major contributors to the underlying theory are:
- Peter Fishburn at the University of Pennsylvania who developed the mathematical equations for calculating downside risk and provided proofs that the Markowitz model was a subset of a richer framework.
- Atchison & Brown at Cambridge University who developed the three parameter lognormal distribution which was a more robust model of the pattern of returns than the bell shaped distribution of MPT.
- Bradley Efron, Stanford University, who developed the bootstrap procedure for better describing the nature of uncertainty in financial markets.
- William Sharpe at Stanford University who developed returns based style analysis that allowed more accurate estimates of risk and return.
- Daniel Kahneman at Princeton & Amos Tversky at Stanford who pioneered the field of Behavioral Finance which contests many of the findings of MPT.