Another conceptual post: According to CAPM, the market portfolio is efficient. The reason is that the market portfolio is always perfectly correlated to itself, and therefore has no idiosyncratic risk. This is what makes the market portfolio efficient… all risks are systematic, since if “the market” moves by X, the “market portfolio” moves by X. This is all very nice, but it seems a bit tautological: I am always exactly where I am. Well, yes, can’t argue with that (at least not without chemical enhancements). The value of the CAPM statement is presumably that all other portfolios (excepting combinations of the market and risk free or borrowed funds) have some degree of ideosyncratic risk that could be eliminated through added diversification. That’s one meaning of “the market is efficient.” The other meaning of efficient markets is that “all information relevant to valuation is instantly incorporated into prices as it becomes available, therefore market behavior is unpredictable to the extent that future events are unpredictable (and predictable events have already been incorporated into the market price).” Now the question: are these two types of efficiency linked? or are we just using the same word, “efficiency,” to refer to two separate conditions (perfect information incorporation, and “no idiosyncratic risk”). If these are two separate meanings of efficient, it is possible that people who believe one type of efficiency don’t necessarily believe in the other. The CAPM explanation is hard to refute, but I don’t think it leads to concluding the information-availability interpretation… or does it?
they’re both related. market efficiency is an assumption and the market portfolio is a derivation as a result of the assumption. one is applied the other is not. market eff. is the bedrock of economics, and in markovitz model he uses that assumption to derive the theoretical market port. the market port. is efficient only because they make the assumption that markets clear and everybody is the same. idio. risk is diversified away. all of the port. on the efficient frontier can be the market port. depending on agent’s preferences.
My understanding of CAPM is that the market portfolio is only one point on the efficient frontier. It is a portfolio that is composed of all exchangeable assets in existence, held in equal proportion to their proportion of all global assets (i.e. a portfolio that has 0.01% of all the equities on the planet, 0.01% of all the debt, 0.01% of all the real estate, 0.01% of all gold, etc.). If you move to other points on the efficient frontier, you get proportions that are different, so it’s not the market portfolio. Different points on the efficient frontier are points where diversifiable risk is minimized for that level of return, but only the market portfolio has *zero* diversifiable risk. I guess that means that the market portfolio is the efficient portfolio with minimum diversifiable risk. Still, I’m trying to figure out how the absence of diversifiable risk leads to the conclusion that information is instantly reflected in prices. If portfolios take a little time to settle on their prices in response to new information, why would this create additional diversifiable risk?
bd…the market portfolio is determined by the investor. it depends on the point of tangency. so yes, it is only one point after you get the ulitity function. therefore, all points on efficient frontier is a possible EMP. i dont’ understand your second question. but “info being instantly reflected in prices” is simply an assumption. they don’t prove this within the capm. its one of those things you just have to accept as being part of the model and a weakness of the model.
On a slightly different note, I am really very sceptical about the market efficiency literature that exists today. A caveat first: I am not an academic, so this is really based 80% on casual observation. However… If I were to look at a share price chart of Vodafone in the UK, I would observe (roughly) that the market cap has halved twice and doubled twice since 2000. To me, this represents an opportunity. What fundamental changes have taken place at VOD in this time period that would explain a halving/doubling of fair value (future cash flows discounted to present value)? Obviously, the market’s perception changed in this way, but it suggests to me the possibility that a novel thinker could have seen the wood through the trees. Second, the market is far too volatile. Again, if the value of the S&P500 is supposed to reflect the present value of future cash flows, the beta is too high. There is a body of literature which, I think, makes this point that the discounted cash flows grow at a relatively steady rate. To give a real world example, though, why is the market falling 2% when the perceived risk of a US recession in 2008 increases slightly (perhaps initial jobless claims came out a little higher than expected). This makes no sense if you are discounting future cash flows. Think about a 50 year time window - why would you give a damn (I’m exaggerating) whether the US will slowdown in 2008? (And I remind you that one of few things we know for sure in the investment game is the Theory of Investment Value - a stock’s intrinsic value is the present value of its future cash flows.) Happily for me, my view is consistent with my employer’s business model, and we have outstanding long-term performance numbers…