Market Portfolio

A market portfolio is a theoretical bundle of investments that includes every type of asset available in the world financial market, with each asset weighted in proportion to its total presence in the market. The expected return of a market portfolio is identical to the expected return of the market as a whole.

A market portfolio, by nature of being completely diversified, is subject only to systematic risk, or risk that affects the market as a whole, and not to unsystematic risk, which is the risk inherent to a particular asset class.

As a simple example of a theoretical market portfolio, assume three companies exist: Company A, Company B and Company C. The market capitalization of Company A is $2 billion, the market capitalization of Company B is $5 billion, and the market capitalization of Company C is $13 billion. Thus, the global market capitalization is $20 billion. The market portfolio consists of each of these companies, which are weighed in the portfolio as follows:

Company A portfolio weight = $2 billion / $20 billion = 10%

Company B portfolio weight = $5 billion / $20 billion = 25%

Company C portfolio weight = $13 billion / $20 billion = 65%

The market portfolio is an essential component of the capital asset pricing model (CAPM). The CAPM shows what an asset's expected return should be based on its amount of systematic risk. The relationship between these two items is expressed in an equation called the security market line. The equation for the security market line is:

Expected return = R(f) + B x (R(m) - R(f))

Where,

R(f) = the risk-free rate

R(m) = the expected return of the market portfolio

B = the beta of the asset in question versus the market portfolio

For example, if the risk-free rate is 3%, the expected return of the market portfolio is 10%, and the beta of the asset with respect to the market portfolio is 1.2, the expected return of the asset is:

Expected return = 3% + 1.2 x (10% - 3%) = 3% + 8.4% = 11.4%

Economist Richard Roll suggested in a 1977 paper that it is impossible to create a truly diversified market portfolio in practice because this portfolio would need to contain a portion of every asset in the world, including collectibles, commodities and basically any item that has marketable value. This is known as "Roll's Critique."