Market portfolio

The market portfolio is a portfolio containing every available asset in proportion to the value of it that exists (i.e. its market cap).

The market portfolio exists at the point at which the securities markets line touches the efficient frontier.

The market portfolio is an important concept from the point of view of modern portfolio theory, but it is important to note that it is not practical to actual construct a market portfolio in this sense as it would have to include every single available asset, not just listed securities, but all alternative investments as well.

That said, it is difficult to believe that the market portfolio would lie on the efficient frontier if it was also not true that the portfolio of all investments in a smaller universe of investments did not also lie on the efficient frontier of that smaller universe.

This is the justification for promoting index tracking as an investment strategy: if the above is correct, then the optimum combination of risk and reward (e.g. the highest return for a given level of risk) will always be produced by the market portfolio plus risk free assets, and an index tracker is the best available proxy for the market portfolio.

It also implies that the combination of risk and return can be improved (higher return for the same risk) by expanding the universe of investments. This is the key justification for investing globally, and for investing in alternative assets.

The concept of a market portfolio still have some importance without modern portfolio theory, but it would not be as central, nor would it imply the same advantages for tracker funds.

Copyright Graeme Pietersz © 2005-2019