What Is 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 return. The critique is an idea that was proposed by economist Richard Roll, who in 1977 theorized that every attempt to diversify a portfolio just becomes an index that attempts to approximate diversification.
- Roll's critique suggests that one can never fully diversify a portfolio and that even a "market portfolio," such as the S&P 500, is only a proxy for a fully-diversified portfolio.
- The capital asset pricing model offers a solid foundation for choosing investments to diversify portfolios, but it's limited because it relies on the S&P 500 to simulate the overall market return.
The Basics of Roll's Critique
The equations that comprise the capital asset pricing model are very sensitive to the formula's variable inputs. A small change in the market's rate of return used in the CAPM formula can have a significant impact on the formula's solution. Because of this and the absence of a true, fully-diversified portfolio, the CAPM formula was considered by Roll to be untestable.
The capital asset pricing model offers a solid foundation for choosing which investments to add to a diversified portfolio, but after learning of Roll's critique and others, many researchers have moved on to using additional, different models. Roll's critique is a reminder of the fact that one can only diversify a portfolio so much, and that investors' attempts to understand and know the market as a whole are just attempts.