What exactly is a market portfolio?
A market portfolio is a notional collection of investments comprising every asset type available in the investment universe, with each asset weighted proportionately to its overall market participation. A market portfolio’s expected return is the same as the market’s overall expected return.
The Fundamentals
A market portfolio, by definition, is exposed only to systematic risk, or risk that affects the market as a whole, rather than unsystematic risk, which is inherent in a specific asset class.
Assume three companies exist in the stock market: Company A, Company B, and Company C. This is a simple example of a theoretical market portfolio. Company A has a market value of $2 billion, Company B has a market capitalization of $5 billion, and Company C has a market capitalization of $13 billion. As a result, the entire market capitalization is $20 billion. Each of these companies is represented in the market portfolio and is weighted as follows:
Company A portfolio weight of $2 billion divided by $20 billion equals 10%.
Portfolio weight of Company B = $5 billion / $20 billion = 25%
Portfolio weight of Company C = $13 billion / $20 billion = 65%
The Capital Asset Pricing Model’s Market Portfolio
The capital asset pricing model (CAPM) relies heavily on the market portfolio. The CAPM, widely used for pricing assets, particularly equities, reveals an asset’s expected return depending on its level of systematic risk. The security market line is an equation that expresses the link between these two items. The security-market line equation is:
R=Rf+βc(Rm−Rf)
Where:
R denotes the expected return.
R f = Risk-free rate
βc = Beta of the asset in question in comparison to the market portfolio
R m =Market portfolio’s expected return
For example, if the risk-free rate is 3%, the market portfolio’s expected return is 10%, and the asset’s Beta concerning the market portfolio is 1.2, the asset’s expected return is:
Return on investment = 3% + 1.2 x (10% – 3%) = 3% + 8.4% = 11.4%
Market Portfolio Limitations
In a 1977 study, economist Richard Roll proposed that it is impossible to establish a genuinely diversified market portfolio in practice since it would require a portion of every asset in the world, including collectibles, commodities, and virtually any object with marketable worth. This argument, known as “Roll’s Critique,” contends that even a broadly diversified market portfolio can only be an index at most and so only approximate complete diversification.
A Market Portfolio in the Real World
“Historical Returns of the Market Portfolio,” a 2017 research project by economists Ronald Q. Doeswijk, Trevin Lam, and Laurens Swinkels, aimed to describe how a worldwide multi-asset portfolio performed from 1960 to 2017. They discovered that, depending on the currency utilized, real compounded returns ranged from 2.87% to 4.93%. The return in US dollars was 4.45%.
Conclusion
- A market portfolio is a made-up collection of all the different kinds of investments possible worldwide. Each investment is given a weighting based on how common it is in the market.
- The capital asset price model is a common way to decide which investments to add to a diverse portfolio. Market portfolios are an essential part of this model.
- Roll’s Critique is an economic theory that makes making a genuinely varied market portfolio challenging. It also says that such a portfolio is just an idea.
