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To Own or not to Own the Market Portfolio (Part 1)

Absent further information, the most-logical portfolio is that which owns them all, in proportion to their worth

Point

Most people who have studied investing believe that they should possess the market portfolio. With their U.S. stocks, they shouldn’t pick and choose; rather, they should own as many positions as possible, presumably through broad index funds. Ditto for their bonds as well as for their overseas holdings. This belief comes courtesy of Professor William Sharpe, who won a Nobel Prize for his troubles.

Of course, most investors don’t follow this precept precisely. They don’t hold a single broad-market index for each asset class. Nonetheless, if they invest through funds rather than through stocks directly, investors will end up owning something that approximates Sharpe’s recommendation. Their portfolios will fluctuate around those benchmarks, but their results shouldn’t stray too far from the mark.

As my colleague Paul Kaplan (to whom this column owes a debt) reminds me, this faith in the market portfolio deserves some rocking. Critically, Sharpe’s conclusion when developing the Capital Asset Pricing Model—that the market portfolio was the single best portfolio for all investors—depends upon the assumption that investors can and will borrow to leverage their portfolios. In addition, the interest rate for their borrowing costs must be the risk-free rate.

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About Author

John Rekenthaler, CFA  John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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