Post-Modern Portfolio Theory

Journal of Financial Planning: September 2005

Executive Summary

• Modern portfolio theory (MPT) and its mean-variance optimization (MVO) model for asset allocation are 
  Nobel Prize-winning theories of global equilibrium, but are unreliable for the primary task to which the 
  financial services industry applies them—building portfolios.
• Post-modern portfolio theory (PMPT) presents a new method of asset allocation that optimizes a portfolio 
  based on returns versus downside risk (downside risk optimization, or DRO) instead of MVO.
• The core innovation of PMPT is its recognition that standard deviation is a poor proxy for how humans 
  experience risk. Risk is an emotional condition—fear of a bad outcome such as fear of loss, fear of 
  underperformance, or fear of failing to achieve a financial goal. Risk is thus more complex than simple 
  variance but can nonetheless be modeled and described mathematically.
• Downside risk (DR) is a definition of risk derived from three sub-measures: downside frequency, mean 
  downside deviation, and downside magnitude. Each of these measures is defined with reference to an 
  investor-specific minimal acceptable return (MAR).
• Portfolios created using MVO and DRO are often similar and the differences in absolute risk and return 
  values small—diversification works regardless of how you measure it. Yet DRO seems to avoid the known 
  errors of MVO and provide a more reliable tool for choosing the "best" portfolio.
• PMPT points the way to an improved science of investing that incorporates not only DRO but also 
  behavioral finance and any other innovation that leads to better outcomes.

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