What is a '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.

BREAKING DOWN 'Market Portfolio'

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 in the Capital Asset Pricing Model

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."

RELATED TERMS
  1. Portfolio Return

    Portfolio return is the gain or loss achieved by a portfolio. ...
  2. Capital Allocation Line - CAL

    The capital allocation line on a graph shows all possible mixes ...
  3. Market Risk Premium

    Market risk premium is the difference between the expected return ...
  4. International Beta

    International beta (often known as "global beta") is a measure ...
  5. Abnormal Return

    A term used to describe the returns generated by a given security ...
  6. Aggressive Investment Strategy

    An aggressive investment strategy is a means of portfolio management ...
Related Articles
  1. Financial Advisor

    Example of Applying Modern Portfolio Theory (MPS)

    Modern Portfolio Theory: brush up on key mathematical framework used in investment portfolio construction.
  2. Investing

    Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  3. Investing

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  4. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
  5. Managing Wealth

    Avoid Future Shock By Protecting Your Portfolio With Futures

    Worried about protecting your portfolio of diversified stocks and assets? Using futures with correct strategies can help.
  6. Managing Wealth

    Achieving Better Returns In Your Portfolio

    We look at three risk factors that best explain the bulk of equity performance.
  7. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  8. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
RELATED FAQS
  1. How can I calculate the expected return of my portfolio?

    Understand the components of the equation used to calculate the expected return of an investor's portfolio. Learn why the ... Read Answer >>
  2. How is the capital asset pricing model (CAPM) represented in the security market ...

    Learn the definition of the capital asset pricing model and how CAPM is used in the calculation and graph of the security ... Read Answer >>
  3. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
  4. According to the CAPM, the expected return on a stock, that is part of a portfolio, ...

    A. the covariance between the stock and the market. B. the variance of the market. C. the market risk premium. D. ... Read Answer >>
  5. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
Trading Center