Post-modern Portfolio Theory - Overview

Overview

Harry Markowitz laid the foundations of MPT, the greatest contribution of which is the establishment of a formal risk/return framework for investment decision-making. By defining investment risk in quantitative terms, Markowitz gave investors a mathematical approach to asset-selection and portfolio management. But there are important limitations to the original MPT formulation.

Two major limitations of MPT are its assumptions that

1. the variance of portfolio returns is the correct measure of investment risk, and
2. the investment returns of all securities and portfolios can be adequately represented by a joint elliptical distribution, such as the normal distribution.

Stated another way, MPT is limited by measures of risk and return that do not always represent the realities of the investment markets.

The assumption of a normal distribution is a major practical limitation, because it is symmetrical. Using the variance (or its square root, the standard deviation) implies that uncertainty about better-than-expected returns is equally averred as uncertainty about returns that are worse than expected. Furthermore, using the normal distribution to model the pattern of investment returns makes investment results with more upside than downside returns appear more risky than they really are. The converse distortion applies to distributions with a predominance of downside returns. The result is that using traditional MPT techniques for measuring investment portfolio construction and evaluation frequently does not accurately modelminvestment reality.

It has long been recognized that investors typically do not view as risky those returns above the minimum they must earn in order to achieve their investment objectives. They believe that risk has to do with the bad outcomes (i.e., returns below a required target), not the good outcomes (i.e., returns in excess of the target) and that losses weigh more heavily than gains. This view has been noted by researchers in finance, economics and psychology, including Sharpe (1964). "Under certain conditions the MVA can be shown to lead to unsatisfactory predictions of (investor) behavior. Markowitz suggests that a model based on the semivariance would be preferable; in light of the formidable computational problems, however, he bases his (MV) analysis on the mean and the standard deviation."

Recent advances in portfolio and financial theory, coupled with increased computing power, have overcome these limitations. The resulting expanded risk/return paradigm is known as Post-Modern Portfolio Theory, or PMPT. Thus, MPT becomes nothing more than a special (symmetrical) case of PMPT.