What is a Market Portfolio?
Let me explain to you what a market portfolio is. It's a theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market. The expected return of this market portfolio matches the expected return of the market as a whole.
The Basics of Market Portfolio
You should know that a market portfolio, by being completely diversified, is only subject to systematic risk—the kind that affects the entire market—and not to unsystematic risk, which is specific to a particular asset class.
Consider this simple example of a theoretical market portfolio. Suppose there are three companies in the stock market: Company A with $2 billion market cap, Company B with $5 billion, and Company C with $13 billion. The total market cap is $20 billion. In the market portfolio, Company A would be weighted at 10% ($2 billion / $20 billion), Company B at 25% ($5 billion / $20 billion), and Company C at 65% ($13 billion / $20 billion).
Key Takeaways
- A market portfolio is a theoretical, diversified group of every type of investment in the world, with each asset weighted in proportion to its total presence in the market.
- Market portfolios are a key part of the capital asset pricing model, a commonly used foundation for choosing which investments to add to a diversified portfolio.
- Roll's Critique is an economic theory that suggests that it is impossible to create a truly diversified market portfolio—and that the concept is a purely theoretical one.
The Market Portfolio in the Capital Asset Pricing Model
I want to tell you about how the market portfolio fits into the Capital Asset Pricing Model (CAPM). This model is widely used for pricing assets, especially equities, and it shows what an asset's expected return should be based on its systematic risk. The relationship is captured in the security market line equation: R = Rf + βc (Rm - Rf), where R is the expected return, Rf is the risk-free rate, βc is the beta of the asset versus the market portfolio, and Rm is the expected return of the market portfolio.
For instance, if the risk-free rate is 3%, the expected return of the market portfolio is 10%, and the asset's beta is 1.2, then the expected return is 3% + 1.2 x (10% - 3%) = 3% + 8.4% = 11.4%.
Limitations of a Market Portfolio
Be aware of the limitations here. Economist Richard Roll argued in a 1977 paper that it's impossible to create a truly diversified market portfolio in practice, because it would need to include a portion of every asset in the world, from collectibles to commodities and anything with marketable value. This is known as Roll's Critique, which points out that even a broad-based market portfolio is at best an index that only approximates full diversification.
Real World Example of a Market Portfolio
Let me share a real-world example. In a 2017 study titled 'Historical Returns of the Market Portfolio,' economists Ronald Q. Doeswijk, Trevin Lam, and Laurens Swinkels examined the performance of a global multi-asset portfolio from 1960 to 2017. They found that real compounded returns varied from 2.87% to 4.93% depending on the currency, with a return of 4.45% in U.S. dollars.
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