Market Portfolio

Market Portfolio: Definition, Theory, and Examples

What is a market portfolio?

A market portfolio is a theoretical, fully diversified bundle that contains every investable asset, with each asset weighted in proportion to its market value. Its expected return equals the expected return of the market as a whole. Because it holds every asset, a market portfolio is exposed only to systematic (market-wide) risk, not unsystematic (asset-specific) risk.

How it works (market-cap weighting)

In practice, assets in a market portfolio are weighted by their market capitalizations. For a simple example with three companies:
– Company A market cap = $2 billion → weight = 2 / 20 = 10%
– Company B market cap = $5 billion → weight = 5 / 20 = 25%
– Company C market cap = $13 billion → weight = 13 / 20 = 65%

This weighting approach is the basis for many broad market indexes and passive investing strategies.

Role in the Capital Asset Pricing Model (CAPM)

The market portfolio is central to CAPM, which links an asset’s expected return to its systematic risk (beta) relative to the market. The security market line equation is:

R = Rf + βc (Rm − Rf)

where:
– R = expected return of the asset
– Rf = risk-free rate
– βc = beta of the asset versus the market portfolio
– Rm = expected return of the market portfolio

Example:
If Rf = 3%, Rm = 10%, and βc = 1.2, then
R = 3% + 1.2 × (10% − 3%) = 3% + 8.4% = 11.4%

Limitations and critique

Roll’s Critique (1977) argues that a truly comprehensive market portfolio is unattainable in practice because it would need to include every asset with marketable value — stocks, bonds, real estate, commodities, collectibles, and more. According to this view, commonly used market proxies (indexes) at best approximate the theoretical market portfolio, so conclusions drawn from CAPM may depend on which proxy is chosen.

Empirical evidence

A study covering 1960–2017 attempted to estimate historical returns of a global multi-asset market portfolio. Depending on the currency used, real compounded returns ranged roughly from 2.9% to 4.9% annually; in U.S. dollars the study reported about 4.45% real compounded return.

Key takeaways

• A market portfolio is a theoretical, fully diversified portfolio containing all investable assets weighted by market value.
• It is exposed only to systematic risk and is a core concept in CAPM for pricing assets via beta.
• Practical proxies (indexes) approximate but do not perfectly replicate the theoretical market portfolio; this limitation is highlighted by Roll’s Critique.