Market Portfolio is a term from portfolio theory that refers to the whole set of investable risky assets, like stocks, bonds, real estate, collectibles and human capital. People often use an index of stocks as a substitute. Portfolio weights are based on market value, or capitalization.
Synonym: The Market
Market Portfolio assumes
that all investors think alike and use optimization.
Ali: Why do we assume the impossible, instead of the possible?
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Market Portfolio definition for investment modeling (4:17)
The script includes two sections where we visualize and demonstrate the concept of the Market Porfolio.
We're sitting in Excel and this is a snippet from our boot camp course.
There we cover all of the curves, lines and dots shown here in one 40-minute video, but because most people can't sit still that long, we break it out into eleven separate 4-5 minute videos, just like this one. I'll provide a link to boot camp video at the end if you'd like the whole story. (See the tutorial Ace Your Portfolio Theory Exam instead).
Ok, let's focus on the Market Portfolio, which is part of Capital Market Theory, developed in the 1960s.
First of all, we have a chart, with expected return on the y-axis and expected risk on the x-axis. Here we are using the term 'expected'. This timeframe assumes we've taken historical data as input, run a regression and arrive at an estimate for expected return. Setting expectations like this is a focus of the boot camp.
The curves and dots on the right represent advancements in Modern Portfolio Theory, covered in other videos.
Now, the Market Portfolio, marked M1 or M2 here, comes from Capital Market Theory, or CAPM, and sits on a theoretically determined portfolio of all risky assets.
Of course this is a concept about equilibrium theory, and academic theories require a lot of assumptions, meaning, a list of other variables held constant. Here is a list of MPT assumptions, and we could tack on another set for Capital Market Theory. If you'd like more than this quick and dirty summary reach out to me for in-depth readings on the topic.
Let's now demonstrate by talking about two points. First, at rf1 an investor invests 100% in Treasury Bills. The second point is here at M1, represents 100% invested in the Market Portfolio, or a diversified basket of all risky assets globally.
Capital Market Theory was important because it demonstrated how investors could choose between, or allocate to, these two assets exclusively. Think about it this way, an investor seeking a higher return must take risk, and move up this line, called the Capital Market Line. One quarter of the way up, the investor might have 75% in T-Bills and 25% in the Market Portfolio. This introduced the concept called asset allocation.
As a take-away, think about this in the context of how central banks maintained near-zero interest rates for years, after the financial crisis.
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Still unclear on the Market Portfolio? Leave a question in the comments section on YouTube or check out the Quant 101 series.
Our trained humans found other terms in the category Capital Market Theory you may find useful.
The whole set of portfolio theory videos, and more, sit on YouTube.