Monday, August 18, 2008

The Market Portfolio

In his book, The Intelligent Portfolio, Christopher L. Jones discusses the average portfolio at great length. This average portfolio is also called the “market portfolio,” and it consists of every class of asset in the proportion that it exists in the marketplace. Jones attributes many qualities to this portfolio, but it has its limitations.

Jones gives a table of how much money is in each type of asset (e.g., cash, various types of bonds, different classes of stock, etc.). If you believe in the market portfolio, then you should buy into each asset class in these proportions.

Jones justifies this saying “when it comes to predicting the future, the market is usually smarter than any one person.” However, he exposes the problem with his reasoning when he says that the market portfolio “represents an efficient allocation of asset classes for an investor with an average tolerance for risk.” What if your tolerance for risk isn’t average?

The perfect airplane seat is only perfect for the average size person. No matter how hard you try to make this seat perfect, it still won’t work well for the shortest gymnast or the tallest basketball player. Few of us have exactly the average tolerance for risk, and therefore few of us would find the market portfolio to be optimal.

For next week’s grocery money, you should stick with cash because the market portfolio is far too risky. But, is the market portfolio suitable for long-term savings? No, because it is too conservative.

The market portfolio consists of all assets including people’s grocery money, retirement savings, and everything in between. Even much of the retirement savings is controlled by pension plans that give strong incentives to their managers to be conservative. A money manager who gets modest, but steady results gets to keep his job.

Overall, the market portfolio is more conservative than necessary for retirement savings. It’s conceivable that given your mix of short-term and long-term investing needs, the market portfolio fits you well. But, it is best to make sensible choices with your grocery money and retirement savings separately instead of blindly following the pack.

2 comments:

  1. Unfortunately the market portfolio can contain some unconventional asset classes such as "housing you can't actually afford and will lose soon". I don't think I'll copy the "average" person.

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  2. Richard: (chuckle) Good one. You'd probably do well to avoid buying your share of lottery tickets as well.

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