Market Portfolio

• Market Portfolio: Definition, Theory, and Examples

A market portfolio is a theoretical bundle of investments that includes every type of asset available in the investment universe, 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 in the stock market: 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 total market capitalization comes to $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%

• William_F_Sharpe_Market_Portfolio.pdf
  • After costs, the return on the average actively managed dollar must be less than the return on the average indexed (passively-managed) dollar.
• Great explanation in The Stock Market Always Wins
  • Look at all traders/investors collectively as one entity
  • Every investor is voting what a market should look like with their individual allocation
  • If you pause at any time and look at what everyone has their money in, you get single collective portfolio
    • Sharpe called this portfolio “the market portfolio”
  • With this portfolio you can capture collective wisdom i.e. all the information that went into the market and its prices
  • You get this wisdom and information for free with the market portfolio
  • Sharpe big insight is that market portfolio is the average of everyones holdings so it must deliver average performance, but it has lower fees so it beats the actively managed (high fees) funds over the long-term