Did you know, the concept of risk and return being correlated did not exist until the late 1950s! It would surprise many that the concept of risk and return was loosely dealt with in the better half of the 20th century.
The only little understanding of this concept came from the traditional adage of ‘Do not place all eggs in one basket’ as people tried to explore why not. But then, those were the times when the investing world largely functioned on conventional approaches to portfolio management.
All of this stood to be changed by one Harry Markowitz who revolutionised the concept of risk, return, and investing through his detailed paper and methodology of investing, popularly referred to as– Modern Portfolio Theory (MPT).
In 1950, Markowitz became the first person to formally attempt to quantify risk and return from a portfolio and depict how diversification helped reduce risk. He was awarded the Nobel Prize in Economics in 1990 for his seminal contribution to the field.
His paper ‘Portfolio Selection’ was considered an antithesis to existing theories that advocated the selection and quality of assets rather than gauging them on risk and return parameters. He presented that a portfolio of several assets may present low volatility compared to individual assets. Even 8 decades later, the fundamentals of this theory hold strong.
Let us dive deeper into modern portfolio theory, its principal components, and its applicability. Also, let us run through post-modern portfolio theory and why the investment world is divided between modern portfolio theory v/s post-modern portfolio theory.
Modern portfolio theory
Combining statistics like mean and variance and probability, Markowitz founded the Modern Portfolio Theory, also known as the mean-variance theory. He created a mathematical model that helped figure the optimum trade-off between risk and return, thus leading to creation of an ‘optimum portfolio.’ The theory, of course, makes assumptions that investors are rational, risk-averse, and would place higher importance on risk than on returns.
While MPT can do nothing about systematic risk, it looks to counter unsystematic risk. It attempts to do so through diversification, wherein not individual risk, but covariance among individual assets determines overall risk.
What is Portfolio risk and how can you assess it ? Read all about it in our article on the TejiMandi blog.
Assume, for instance, that an individual is presented with two assets – A and B that provide a 5% annual return. Now, asset B is comparatively more volatile than asset A. Here, MPT suggests that the individual will choose asset A over B as the risk is on the lower arena for similar returns.
Now, the next question could be – what level of diversification is optimum such that risk is minimized and returns are maximized?
What is diversification of portfolio? How does it help with achieving investment goals? Read in our article on the TejiMandi blog.
This can be done through what is popularly known as the ‘Efficient Frontier.’
Efficient Frontier is a graphical representation of various combinations of risk and return of different securities. For every level of risk, a return can be calculated or vice versa. Now, any portfolio that falls below or above the frontier line is considered suboptimal because it may either be carrying too much risk or may have lesser returns.
Look at the graph below to have a better understanding.
The portfolios on the right have a higher degree of risk compared to others. Portfolios above the line are considered optimum as they have the highest return for a given risk.
Efficient Frontier depicts the importance of diversification. However, the MPT may depend on several factors like time horizon, investment period, income, etc. Also, this theory is biased toward the assumption that the variance of return is an accurate measure of risk. The variance can be attributed to various factors and thus become a huge limitation of this theory.
Countering this, Brian M.Rom and Kathleen Ferguson introduced the Post Modern Portfolio Theory (PMPT).
Post-modern portfolio theory
Rom and Ferguson, both software engineers, noticed significant limitations in MPT theory that heavily depended on standard deviation and variance to measure risk. Both engineers wrote a paper in 1993 introducing the post-modern portfolio theory to the world, which is considered a paradigm shift in the framework of portfolio management.
This theory employs an advanced version of Sharpe’s ratio (used in MPT), called the Sortino ratio. The Sortino ratio takes into account the downside deviation (focus on returns falling below the minimum acceptable threshold) or negative returns. The PMPT uses the standard deviation of these negative returns to measure risk against MPT, which uses the standard deviation of all returns to quantify risk.
While MPT may be considered passive in today’s time, PMPT is a more active approach wherein investors seek more than just normal returns on considered risk. PMPT completely redefines risk by considering downside risk and downside deviations (maximum level to which an asset price can drop by).
Want to know more about standard deviation and its importance to investment planning? Check out our article titled What is Standard Deviation? on the TejiMandi blog.
Modern portfolio theory v/s post-modern portfolio theory
The difference between the above-mentioned theory calls for an interesting debate. While these theories are considered opposites, a closer look may break the same myth. It is always to be remembered that PMPT theory is an extension and modified version of the MPT. It does not negate the MPT as wrong or ineffective. PMPT aims to address the shortcomings of the MPT and provide an accurate risk-return analysis.
The most significant difference between the two theories is their approach to risk. Both theories define and employ risk differently. While MPT uses variance, standard deviation, Sharpe’s ratio, and other similar statistical tools to measure risk, PMPT replaces them with downside deviation, and Sortino ratio to quantify the same.
Conclusion
Modern portfolio theory is the key foundation of various financial institutions and schemes globally. The theory stresses diversification as a key factor to achieve optimum risk-return portfolios. However, with dynamic changes in the investing world, the theory was revamped as post-modern portfolio theory, which redefined risk, thus also redefining returns. PMPT may be considered an extended and better-defined version of MPT. Both theories run on several assumptions which need to be accounted for before arriving at a conclusion.
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