Market portfolio is a portfolio consisting of a
weighted sum
A weight function is a mathematical device used when performing a sum, integral, or average to give some elements more "weight" or influence on the result than other elements in the same set. The result of this application of a weight function is ...
of every
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
in the market, with weights in the proportions that they exist in the market, with the necessary assumption that these assets are
infinitely divisible
Infinite divisibility arises in different ways in philosophy, physics, economics, order theory (a branch of mathematics), and probability theory (also a branch of mathematics). One may speak of infinite divisibility, or the lack thereof, of matter, ...
.
Richard Roll
Richard Roll (born October 31, 1939) is an American economist and professor of finance at UCLA, best known for his work on portfolio theory and asset pricing, both theoretical and empirical.
He earned his bachelor's degree in aerospace enginee ...
's critique states that this is only a theoretical concept, as to create a market portfolio for investment purposes in practice would necessarily include every single possible available asset, including real estate, precious metals, stamp collections, jewelry, and anything with any worth, as the theoretical market being referred to would be the world market.
There is some question of whether what is used for the market portfolio really matters. Some authors say that it does not make a big difference; you can use any representative index and get similar results. Roll gave an example where different indexes produce much different results, and that by choosing the index you can get any ranking you want. Brown and Brown (1987) examine this, using different indexes such as stocks only, stocks and bonds, and stocks plus bonds plus real estate. They find that using a market that includes real estate produces much different results. For example, with one measurement most mutual funds have alpha close to zero, while with another measurement most of them have significantly negative alpha.
Most index providers give indices for different components such as stocks only, bonds only, et cetera. As a result, proxies for the market (such as the
FTSE 100
The Financial Times Stock Exchange 100 Index, also called the FTSE 100 Index, FTSE 100, FTSE, or, informally, the "Footsie" , is a share index of the 100 companies listed on the London Stock Exchange with (in principle) the highest market ...
in the
UK,
DAX
Dax or DAX may refer to:
Business and organizations
* DAX, stock market index of the top 40 German companies
** DAX 100, an expanded index of 100 stocks, superseded by the HDAX
** TecDAX, stock index of the top 30 German technology firms
* Dax ...
in Germany or the
S&P 500
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices. As of D ...
in the US) are used in practice by investors.
Roll's critique Roll's critique is a famous analysis of the validity of empirical tests of the capital asset pricing model (CAPM) by Richard Roll. It concerns methods to formally test the statement of the CAPM, the equation
:E(R_i) = R_f + \beta_ (R_m) - R_f\,
T ...
states that these proxies cannot provide an accurate representation of the entire market.
The concept of a market portfolio plays an important role in many financial theories and models, including the
capital asset pricing model
In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
The model takes into accou ...
where it is the only fund in which investors need to invest, to be supplemented only by a risk-free asset, depending upon each investor's attitude towards risk.
Sharpe (2010) notes that many investors are at least targeted to a fixed ratio (e.g. 60% stocks, 40% bonds). He points out that this is sort of contrarian. The holdings of all investors combined must, by equation, be in the cap-weighted proportions. So many investors following this strategy implies some other investors must follow a buy-high, sell-low (trend following) strategy. He then says that he doesn't like it and people should use adjustments to the market proportions instead.
The portfolio of the average investor contains important information for strategic asset allocation purposes. This portfolio shows the relative value of all assets according to the market crowd, which one could interpret as a benchmark for the average investor. Several authors have collected data to determine the composition of the global market portfolio since 1960.
The returns on the market portfolio realizes a compounded real return of 4.43% with a standard deviation of 11.2% from 1960 until 2017. In the inflationary period from 1960 to 1979, the compounded real return of the GMP is 3.24%, while this is 6.01% in the disinflationary period from 1980 to 2017. The reward for the average investor is a compounded return of 3.39%-points above the risk-free rate.
See also
*
Asset allocation
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment tim ...
*
Capital market line
Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance criteri ...
*
Capital allocation line
Capital allocation line (CAL) is a graph created by investors to measure the risk of risky and risk-free assets. The graph displays the return to be made by taking on a certain level of risk. Its slope is known as the "reward-to-variability ratio". ...
*
Security market line
Security market line (SML) is the representation of the capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk. The risk of an individual risky security re ...
*
Security characteristic line
Security characteristic line (SCL) is a regression line, plotting performance of a particular security or portfolio against that of the market portfolio at every point in time. The SCL is plotted on a graph where the Y-axis is the excess return on ...
References
External links
The Market Portfolio May be Mean-Variance Efficient After All
{{DEFAULTSORT:Market Portfolio
Market risk
Investment