What is a Market Portfolio?
A market portfolio encompasses a theoretical bundle of investments, containing every type of asset within the investment universe, each weighted according to its market presence. The expected return of a market portfolio mirrors that of the market as a whole.
Essential Principles of Market Portfolio
A market portfolio, being completely diversified by nature, is only subjected to systematic risk, the overarching risk that impacts the entire market. Unsystematic risk, specific to particular asset classes, does not influence a market portfolio.
A Practical Illustration
Consider a hypothetical stock market with three companies: Company A, Company B, and Company C. The market capitalization for each is as follows:
- Company A: $2 billion
- Company B: $5 billion
- Company C: $13 billion
Given a total market capitalization of $20 billion, the portfolio weights are:
- Company A: $2 billion / $20 billion = 10%
- Company B: $5 billion / $20 billion = 25%
- Company C: $13 billion / $20 billion = 65%
Key Takeaways
- A market portfolio is a theoretical, diversified assembly of every global investment, with each asset weighted by its market representation.
- It plays a crucial role in the Capital Asset Pricing Model (CAPM), a cornerstone for selecting investments within a diversified portfolio.
- According to Roll’s Critique, achieving a truly diversified market portfolio is theoretical, as it would need every asset in the world.
The Market Portfolio and the CAPM
In the Capital Asset Pricing Model (CAPM), the market portfolio is fundamental. The CAPM calculates an asset’s expected return based on its systematic risk, depicted through the Security Market Line (SML):
R = Rf + βc (Rm - Rf)
where:
R = Expected return
Rf = Risk-free rate
βc = Beta of the asset relative to the market portfolio
Rm = Expected return of the market portfolio
For instance, if the risk-free rate is 3%, the market portfolio’s expected return is 10%, and an asset’s beta is 1.2, the formula yields:
Expected return = 3% + 1.2 * (10% - 3%) = 3% + 8.4% = 11.4%
Limitations of a Market Portfolio
Economist Richard Roll posited that constructing a truly diversified market portfolio is impractical. Known as Roll’s Critique, this theory highlights that an actual market portfolio would need fractional ownership of all global assets, including tangibles like collectibles and tradable commodities, thus making true diversification an unattainable ideal.
A Real-World Illustration
In a 2017 study, economists Ronald Q. Doeswijk, Trevin Lam, and Laurens Swinkels investigated the performance of a global multi-asset market portfolio from 1960 to 2017. They observed real compounded returns ranging from 2.87% to 4.93%, with returns measured in U.S. dollars at 4.45%.
Related Terms: Systematic Risk, Capital Asset Pricing Model, Diversification, Market Capitalization, Security Market Line
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What is a market portfolio?
- [x] A portfolio consisting of all available assets in the market weighted by their market values
- [ ] A portfolio consisting solely of high-risk assets
- [ ] A portfolio made up exclusively of risk-free assets
- [ ] A portfolio consisting of selectively chosen stocks by an analyst
## Which of the following best describes the composition of a market portfolio?
- [ ] Equal weight of every available asset
- [ ] Only stocks from the top 10 largest companies
- [x] All assets in the market proportionally based on their market capitalization
- [ ] Only assets with high dividend yield
## What is one major assumption of the Capital Market Line (CML) regarding market portfolios?
- [ ] Market portfolio is composed solely of bonds
- [ ] Market portfolio performs worse than individual selected assets
- [x] Market portfolio always lies on the efficient frontier
- [ ] Market portfolio includes private equity and unlisted companies
## Which theory prominently utilizes the concept of a market portfolio?
- [ ] Prospect Theory
- [ ] Behavioral Finance Theory
- [x] Capital Asset Pricing Model (CAPM)
- [ ] Modern Portfolio Theory (MPT)
## Why is a market portfolio considered to minimize unsystematic risk?
- [x] Because it is fully diversified by containing all market assets
- [ ] Because it only includes risk-free assets
- [ ] Because the proportion of assets never changes
- [ ] Because it consists only of stable blue-chip stocks
## How does an individual asset's performance relate to the market portfolio in the context of CAPM?
- [ ] It is assessed independently without regard to the market
- [ ] It always outperforms the market portfolio
- [x] It is estimated based on its beta relative to the market portfolio
- [ ] It can avoid systematic risk entirely
## What is "market capitalization" in relation to a market portfolio?
- [x] The total value of a company's shares of stock within the market
- [ ] The initial price offered during an IPO
- [ ] The daily trading volume of a stock
- [ ] The intrinsic value of a stock at a given point in time
## Which indices could broadly represent a market portfolio?
- [x] S&P 500
- [ ] Wilshire 4500 Growth Index
- [ ] Tech-Heavy NASDAQ
- [x] MSCI World Index
## In practice, why might constructing a perfect market portfolio be challenging?
- [ ] It requires active management supervision
- [ ] Many assets have negative returns
- [x] It is difficult to include every available asset in the market
- [ ] Typically returns are always consistent
## How does diversification in a market portfolio impact its risk profile?
- [x] It reduces unsystematic risk by spreading investments across multiple assets
- [ ] It increases exposure to currency risk
- [ ] It makes the portfolio more vulnerable to sector-specific downturns
- [ ] It eliminates all types of risk
These quizzes should cover various important aspects of the Market Portfolio concept as described in the Investopedia financial dictionary.
