How Post-Modern Portfolio Theory Came to Be
Posted on: 03/05/2015
We’ve spent most of our time talking about iSectors Post-MPT Growth Allocation—since we recently celebrated its 10 year anniversary of live performance results last month (February 2005-2015).
It should be known that iSectors isn’t the only resource for good information about Post-MPT. For example, the article below provides a good definition and explanation of post-modern portfolio theory, as well as the history and origins of the theory itself. It should also be noted that while we have gone over the history of the “original MPT” before, we haven’t ever really fully explained how Post-Modern Portfolio Theory came to be. So enjoy the article below—it details that history, along with an explanation of Post-MPT that was not written by us, for once.
By the way, this article comes from the mutual funds section of about.com. Considering the fact that iSectors is an “An ETF Investment Strategist,” we are usually not a big proponent of mutual funds (which you can read more about here, here, and here). However, this is still a very informative article that backs up a lot of the things we have been preaching about since 2008, even though mutual funds are not typically iSectors’ investment vehicle of choice.
Post-MPT (Post-Modern Portfolio Theory) Definition, Investment Strategy, and Differences with MPT
Definition: Post-Modern Portfolio Theory (Post-MPT) is an investing theory and strategic investment style that is a variation of Modern Portfolio Theory (MPT). Similar to MPT, Post-MPT is an investing method where the investor attempts to take minimal level of market risk, through diversification, to capture maximum-level returns for a given portfolio of investments.
Post-MPT History and Difference with MPT
Post-MPT is the culmination of research from 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 term post-modern portfolio theory was first used in 1991 to describe portfolio construction software created by engineers Brian M. Rom and Kathleen Ferguson. Rom and Ferguson first publicly described their ideas about Post-MPT in the 1993 Journal of Investing article, Post-Modern Portfolio Theory Comes of Age.
The difference between Post-MPT and MPT is the way they define risk and build portfolios based upon this risk. MPT sees risk as symmetrical; the portfolio construction is comprised of several investments with various risk levels that combine to achieve a reasonable return. It is more a big picture view of risk and return. Rom and Ferguson explain that “MPT is limited by measures of risk and return that do not always represent the realities of the investment markets.”
However, Post-MPT sees risk as asymmetrical; the way investors feel about losses is not the exact opposite mirror image of how they feel about gains; and each economic and market environment is unique. Post-MPT sees that investors do not always act rationally. Therefore, Post-MPT accounts for the behavioral aspects of the investor herd.
Simple Explanation of Post-Modern Portfolio Theory
Your humble Mutual Funds Guide is not a math genius but I am an investment advisor and Certified Financial Planner (TM) that does not completely adhere to MPT or Post-MPT, which enables (or forces) me to provide an understandable explanation of Post-MPT. In different words, I have a simple mind and can only explain things simply!
Post-MPT is an investing theory that recognizes that mathematical models, such as Modern Portfolio Theory, look good on paper but statistical science does not explain human behavior, nor does it provide the ideal means of profiting from human behavior! For example, science can explain emotion but it has limitations in predicting it!
An investing strategy that has parallels to Post-MPT (and incorporates much of its most effective aspects) is tactical asset allocation, which will guide an investor to purposely “go against the crowd” at times by over-weighting or under-weighting certain assets or investment types that have been overly influenced by irrational investor behavior (i.e. extremely high and overbought or extremely low and oversold assets and investment types).
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
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