Post-modern portfolio theory

Post-modern portfolio theory (or PMPT) is an extension of the traditional modern portfolio theory (MPT, which is an application of mean-variance analysis or MVA). Both theories propose how rational investors should use diversification to optimize their portfolios, and how a risky asset should be priced.'Before we make an investment, we don't know what the outcome will be... After the investment is made, and we want to measure its performance, all we know is what the outcome was, not what it could have been. To cope with this uncertainty, we assume that a reasonable estimate of the range of possible returns, as well as the probabilities associated with estimation of those returns...In statistical terms, the shape of uncertainty is called a probability distribution. In other words, looking at just the discrete monthly or annual values does not tell the whole story.' Post-modern portfolio theory (or PMPT) is an extension of the traditional modern portfolio theory (MPT, which is an application of mean-variance analysis or MVA). Both theories propose how rational investors should use diversification to optimize their portfolios, and how a risky asset should be priced. The term post-modern portfolio theory was created in 1991 by software entrepreneurs Brian M. Rom and Kathleen Ferguson to differentiate the portfolio-construction software developed by their company, Investment Technologies, from those provided by the traditional modern portfolio theory. It first appeared in the literature in 1993 in an article by Rom and Ferguson in The Journal of Performance Measurement. It combines the theoretical research of many authors and has expanded over several decades as academics at universities in many countries tested these theories to determine whether or not they had merit. The essential difference between PMPT and the modern portfolio theory of Markowitz and Sharpe (MPT) is that PMPT focuses on the return that must be earned on the assets in a portfolio in order to meet some future payout. This internal rate of return (IRR) is the link between assets and liabilities. PMPT measures risk and reward relative to this IRR while MPT ignores this IRR and measures risk as dispersion about the mean or average return. The result is substantially different portfolio constructions. Empirical investigations began in 1981 at the Pension Research Institute (PRI) at San Francisco State University. Dr. Hal Forsey and Dr. Frank Sortino were trying to apply Peter Fishburn's theory published in 1977 to Pension Fund Management. The result was an asset allocation model that PRI licensed Brian Rom to market in 1988. Mr. Rom coined the term PMPT and began using it to market portfolio optimization and performance measurement software developed by his company. These systems were built on the PRI downside risk algorithms. Sortino and Steven Satchell at Cambridge University co-authored the first book on PMPT. This was intended as a graduate seminar text in portfolio management. A more recent book by Sortino was written for practitioners. The first publication in a major journal was co-authored by Sortino and Dr. Robert van der Meer, then at Shell Oil Netherlands. The concept was popularized by numerous articles by Sortino in Pensions and Investments magazine and Dr. Sortino's Blog: www.pmpt.me.