Insight: Post-Modern Portfolio Theory

Post-Modern Portfolio Theory attempts to build on the mathematical foundations of Modern Portfolio Theory while recognizing the abnormal results or deviations proposed by Behavioral Economics.

Post-Modern Portfolio Theory addresses the investor’s non-symmetrical view of risk. Modern Portfolio Theory assumes that investors dislike abnormally high returns as much as abnormally low returns. However, it has been long known, (even by Sharpe in 1964) that investors are not averse to the risk of returns above their target return in the same way they are averse to the risk of returns below their target return. During the development of Modern Portfolio Theory, Markowitz suggested acknowledging this issue by using a model based on semi-variance instead of mean-variance. However, because of the technological limitations of the time, he decided to use mean-variance with its simpler computational requirements.

Semi-variance takes mean-variance one step further. It tries to account for a limitation of mean-variance in which a stock with more upside than downside returns can appear to be more risky than it actually is. Semi-variance also tries to account for a stock with more downside than upside returns that appears safer than it actually is. This is important because investors have a tendency to let gains on "winning stocks" run because they often mistakenly believe that a stock that has performed well, will continue to do so, and therefore is less risky than a stock that has performed poorly.

In addition, Post-Modern Portfolio Theory employs the Sortino Ratio as an improvement upon the concept of the Sharpe ratio. The Sortino Ratio allows the calculation (and rank) of investment choices based on a target return and a measure of downside risk below the target return. In contrast, the Sharpe ratio calculates the excess return over a non-risk investment alternative divided by the standard deviation. In short, the Sortino Ratio provides a more useful, real world, tool to rank investments against the often-irrational choice of an investor.