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Separation theorem / market portfolio

Discussion in 'CT8' started by Benjamin, Apr 11, 2016.

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  1. Benjamin

    Benjamin Member

    The notes states about the market portfolio: "Because this is the portfolio held in different quantites by all investors, it must consist of all risky assets in proportion to their market capitalistation."

    Why is that the case?
     
    Benjamin, Apr 11, 2016
    #1
  2. Steve Hales

    Steve Hales ActEd Tutor Staff Member

    Under this model, the decision for all investors is this: what's the total level of cash and the total level of risky assets that I'm prepared to hold? If you take a look at the efficient frontier diagram in the Course Notes you'll see that it only coincides with the "old" efficient frontier (the curved one before the risk-free asset was introduced) in one place. This means that all investors will hold cash, and an amount of this special portfolio, called the market portfolio. If this is now the only efficient way for investors to access the risky assets, and given that in aggregate investors will be holding all available risky assets, it can only be the case that the constituent parts of the market portfolio are the risky assets in proportion to their market capitalisation. Otherwise there would be some risky assets floating about in the market but not being owned by any investor.
     
    Steve Hales, Apr 11, 2016
    #2
  3. Whippet1

    Whippet1 Member

    According to CAPM, all investors hold a combination of the same portfolio M of risky assets and the risk-free asset - though different investors will hold different combinations at different points along the efficient frontier / capital market line

    So:

    (1) All investors hold the same combination of risky assets - albeit in different absolute amounts, as a wealthy investor wil hold more of each asset than a poor investor.

    (2) Also, all risky assets must be held by someone.

    The only way both of this two things can be true is if the proportions in the portfolio of risky assets are based on the market capitalisations, i.e. the portfolio of risky assets M is the market portfolio.

    So, in practice, if the FTSE All-Share index is the market portfolio. Then CAPM suggests that all investors must hold a combination of risky assets, in the form of a FTSE All-Share index tracker fund, plus the risk-free asset (cash) - and if everyone holds their risky assets in the form of a FTSE All-Share index tracker fund, then all the shares in the All-Share index will be held by someone, as must be the case in practice.
     
    Whippet1, Apr 15, 2016
    #3
  4. George Philip

    George Philip Active Member

    Why is this assumption held? Why is it necessary for all investors to hold same combination of risky assets?
     
    George Philip, Nov 25, 2021
    #4
  5. CapitalActuary

    CapitalActuary Ton up Member

    You assume all the investors are rational and risk averse, so within CAPM they’re all going to come to the same conclusions about what to hold.

    In reality yeah this doesn’t hold. Different investors are rational to different extents and have different investments goals, needs, and preferences.
     
    CapitalActuary, Nov 25, 2021
    #5
  6. George Philip

    George Philip Active Member

    Thank you for your explanation!
     
    George Philip, Nov 27, 2021
    #6

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