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To Own or not to Own the Market Portfolio (Part 2)

4 Reasons Not to Own the Market Portfolio

A False Assumption

Friday's column pointed out that, contrary to common belief, investors aren't necessarily being theoretically correct if they index the entire stock market. As Dr. Harry Markowitz pointed out, some years back, the postulate that rational investors should own all equities, in proportion to their stock-market worth, relies on the assumption that stock owners will routinely leverage at the risk-free rate. As that is not the case, the theory collapses. There may be valid grounds to own something other than the market portfolio.

(Of course, most investors, behaving as butterfly collectors rather than as engineers, own something other than the market portfolio. But those differences owe to accidental decisions. This column, instead, concerns the intentional reasons that one might digress from orthodoxy.)

This finding comes, indirectly, from Markowitz's paper. Markowitz shows that if leverage is not easily affordable and common, then aggressive investors will deviate from the market portfolio. Per the very logic that recommends the market portfolio--that is, the capital asset pricing model (CAPM)--the higher a stock's beta, the higher its expected returns. Without the use of leverage as a tool, the aggressive buyers will crowd into high-beta stocks.

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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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