The spirit of the Olympics has us contemplating how the modern Pentathlon compares to post-modern Portfolio Theory. On the surface they seem quite diverse, but they actually have several things in common.
1. Both are Evolutions of an Earlier Historical Benchmark
The modern pentathlon, allegedly founded by Baron Pierre de Coubertin (Viktor Black has also claimed authorship) was introduced to the 1912 Olympic Games to simulate the skillsets required of a cavalry officer engaged behind enemy lines. These skillsets consisted of Fencing, Shooting, Show Jumping, Running, and Swimming. This modern pentathlon is an iteration of the ancient version, which consisted of javelin, discus, wrestling, long jump, and running.
Post-modern portfolio theory (PMPT) is a methodology used for portfolio optimization that limits the downside of risk. In 1991, two software engineers named Brian M. Rom and Kathleen W. Ferguson, created PMPT after noting what they perceived to be two significant limitations of Modern Portfolio Theory (MPT). MPT was originally published by Harry Markowitz in 1952, which detailed how best to construct a portfolio that maximized expected return based on a given level of market risk. Markowitz would ultimately be awarded a Nobel Prize for his contributions.
2. Both Involve a Dogmatic Focus on Diversification
When training for the Games, the modern pentathlete must distribute their total available amount of training time across the five disciplines in a way that maximizes the outcome of the competition. The allocation of time becomes particularly challenging with the theory that a skilled cavalry officer should be proficient on an unfamiliar horse. Consistent with the spirit of the last century, the pentathlete is paired with a horse in a draw only 20 minutes before the competition.
Both MPT and PMPT place tremendous emphasis on the benefits of diversification; creating portfolios with assets that are non-correlated. The key differentiator is that while MPT uses the standard deviation of all returns as a measure of risk, PMPT uses the standard deviation of negative returns as a measure of risk.
3. Both Involve Accepting Some Degree of Risk
Victory in the show jumping discipline must necessarily involve the taking of risk, particularly while riding an unfamiliar horse. Competitors wear helmets for a very good reason.
Similarly, an investor must accept a certain degree of risk to generate a positive rate of return after fees, taxes, and inflation. This might involve geo-political risk, market risk, interest rate risk, liquidity risk, etc.
The key for both is to take smart risks, particularly when riding an unfamiliar horse.
Evolution of historical benchmarks, dogmatic focus on diversification and acceptance of risk are interesting common threads shared by the modern Pentathlon and post-modern Portfolio Theory.