Optimization of portfolio risk Essay

This paper is a critique one the article entitled “Post-Modern Portfolio Theory” by Swisher and Kasten (2005). The framework for this critique is to determine whether there ground to agree or disagree on the claims of the authors as against the evidence they presented. Swisher and Kasten asserted about the unreliability of Modern portfolio theory (MPT) and its mean-variance optimization (MVO) model for asset allocation in the financial services industry particularly on building portfolios.

They instead suggested the use of post-modern portfolio theory (PMPT) which presents a new method of asset location that optimizes a portfolio based on return versus downside risk (down side optimization, or DRO) instead of MVO. What makes PMPT different from PMT as explained by the authors is its recognition that standard deviation as a poor proxy in relation to humans experience on risk. They are therefore arguing on the basis of behavioral finance which appears to be not evident under PMT in addition to mathematical implication of the model.

They explained that risk is an emotional condition which may be “fear of a bad outcome such as fear of loss, fear of underperformance, or fear of failing to achieve a financial goal. ” (Swisher and Kasten, 2005). They simply cannot equate risks with variability as they argue that risk is “more complex than simple variance” although they admitted that it (risk) may be modeled and described mathematically. The authors explained that downside risk (DR) is risk definition taken from three sub-measures which include downside frequency, mean downside deviation, and downside magnitude.

They added that each sub-measure must be defined with reference to an investor-specific minimal acceptable return (MAR) (Swisher and Kasten, 2005) . In translating their mathematical analysis, Swisher and Kasten (2005) stated that “people like to make money, not lose” and the chance of making above-average amounts to money frequently is given a heavier weight as against a tiny chance of success in lottery.

In other words, the investors would go where there are more chances so that it will be accepted as part of the chance when an investment may turn out to perform poorly but they would hope that it will not to perform very poorly or as often. Swisher and Kasten, (2005) acknowledged the elegance of the mathematical mode for describing the perfect investment although incidentally they found the model called modern portfolio theory (MPT) wrong.

They acknowledged that the defect is the provision of inefficient portfolios which goes without saying the it is contradicting what it is supposed to accomplish, that is efficient asset allocation or building of portfolio. The same authors took courage in declaring that the primary reason why MPT produces inefficient portfolios is the erroneous act of equating standard deviation with risk. They explained that risk is something else, and there is a need to have a better mechanical framework to describe it. Their paper therefore suggested a better framework for building of better portfolios through downside risk optimization (DRO).

They of course defined DRO as “optimization of portfolio risk versus return using downside risk as the definition of risk instead of standard deviation. ” (Swisher and Kasten, 2005). To be more convincing in their proposed model for through the use of DRO under PMPT, Swisher and Kasten (2005) asserted that DRO is superior to MVO under MPT as an asset allocation tool using the following arguments in support: The first one is the possibility that standard deviation can lead to ridiculous results when used as a measure of risks while downside risk (DR) does the same more closely in capturing the human conception of risk as earlier defined.

The second argument is the reality that financial asset returns do not behave as what a normal distribution tries to paint and assume, thus even if for the sake of argument volatility is taken as a perfect representation of risk, the result will still not work. The third one, which strengthened more their position, is the better performance of DRO over MVO when they demonstrated head to head comparison of portfolios (Swisher and Kasten, 2005). More importantly the result of the comparison the performance of the two produced conflicting results hence one could only be correct.

This was in fact the authors’ basis in declaring that MPT produces inefficient portfolios. It can be concluded that there is basis to the claim of the authors that PMPT works better than MPT in building portfolios. They were able to demonstrate with evidence about their assertion by using DRO as against MVO in their comparison. There is basis to agree with the authors claim that PMPT points the way to an improved science of investing that incorporates not only DRO but also behavioral finance as against MPT.

Given this reason and a number of failures caused by MPT in the past there is basis to give due credit to the proposal of the author for PMPT which justifies its use by investors and analysts as a better alternative in asset allocation. Reference: Swisher and Kasten (2005) Post-Modern Portfolio Theory, Journal of Financial Planning, {www document} URL http://www. fpanet. org/journal/articles/2005_Issues/jfp0905-art7. cfm, Accessed January 22,2008.