Postmodern Portfolio Theory and Adverse Risk
Postmodern portfolio theory explains investor behavior and the optimal portfolio selection criterion based on the relationship between return and adverse risk. In this theory, adverse risk is defined as a risk measurement indicator of "the probability of negative future return fluctuations." Postmodern portfolio theory makes a clear distinction between favorable and unfavorable fluctuations. In other words, only fluctuations below the investor's target rate of return are considered risk, while all fluctuations above this target are considered investment opportunities to achieve the desired rate of return.
The most important innovation of postmodern portfolio theory over modern portfolio theory is the new recognition that traditional risk measures such as standard deviation and beta are not appropriate representatives of what human experience perceives as risk. Risk as an emotional state is more a reflection of the fear of an adverse event such as loss or performance below expectations or failure to achieve the desired goal; Therefore, measures of adverse risk can better explain it mathematically. In the postmodern portfolio theory, two major advances are seen compared to the modern portfolio theory:
1. The use of adverse risk instead of standard deviation (SD) as a risk measurement tool.
2. The postmodern portfolio theory also includes non-normal return distributions.
And it considers the application of this theory in performance evaluation, portfolio optimization and asset allocation.
Therefore, investors who care a lot about adverse risk demand a risk premium for holding assets that have higher downside returns than upside returns. As a result, assets that have negative skewness; that is, they are more likely to cause losses and in other words, their downside returns have a greater absolute size than their upside returns, will be less attractive to investors and demand higher returns and are less priced. Conversely, assets with positive skewness are more attractive and require less risk premium because they have a greater potential for profit than possible losses. In general, optimization procedures are proposed in both modern portfolio theory and metamodern portfolio theory, which require the determination of the statistical distribution of the asset's rate of return. Unlike modern portfolio theory, which allows only two-parameter symmetric distributions, metamodern portfolio theory includes a wider class of asymmetric distributions. In general, optimization studies of metamodern portfolio theory provide more accurate results because they consider an accurate proxy for the correct shape of the return distribution of each asset. In general, metamodern portfolio theory is compatible with highly skewed investment strategies, portfolio insurance theory, the use of options in portfolios, and other derivative-based programs.