Thursday, February 16, 2006

FPA Journal - Post-Modern Portfolio Theory

Interesting read on using 'down-side' deviation versus the standard deviation as a truer measure of investment risk.

FPA Journal - Post-Modern Portfolio Theory:
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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