DEFINITION of 'Roll's Critique'

Roll's Critique is an economic idea that suggests that it is impossible to create or observe a truly diversified market portfolio. This is an important idea because a truly diversified portfolio is one of the key variables of the capital asset pricing model (CAPM), which is a widely used tool among market analysts. According to this view, a true "market portfolio" would include every investment in every market, including commodities, collectibles and virtually anything with marketable value. Those who still use the capital asset pricing model do so with a market index, such as the S&P 500, as a proxy for the overall market. The critique is attributed to economist Richard Roll.

BREAKING DOWN 'Roll's Critique'

The equations that make up the capital asset pricing model are highly sensitive to the initial variables. A small change in the market rate of return (as it is entered in the formula) can have a large impact on the solution set. The capital asset pricing model presents a solid framework for adding an investment to a diversified portfolio, but due to Roll's critique and others, many researchers have expanded to different models. Roll's critique reminds us of the important fact that we can only diversify so much, and that our attempts to know the market as a whole remain just that — attempts.

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