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Unit 7: Efficient Market Theory

will sit above the efficient frontier – i.e. offering a higher return for the same risk as the Notes
point below it on the frontier.
The investor who borrows money to fund his/her purchase of the risky assets has a
negative risk-free weighting—i.e. a leveraged portfolio. Here the return is geared to the
risky portfolio. This combination will again offer a return superior to those on the frontier.

Figure 7.6

Example: Good Portfolio / Diversification
A portfolio should consist of asset classes such as Bonds, stocks, real estate and commodities. I
will not put insurance as an asset class because the insurance company will have to go and invest
that into these asset classes anyway. A US investor can invest in the world. In Bonds, you can
invest in US Government Bonds (has some tax advantages, esp I Bonds), State and local municipal
bonds, Corporate bonds, International developed countries bonds and Emerging market bonds.
Though the first three type should be enough for most.
For stocks, a US investor can invest in the world. You can apportion some % for US Stocks some
% for International Dev mkts (Europe, Japan, Australia, Canada) and some % for Emerging
markets (China, Russia, India, Brazil, Mexico, Turkey etc). Also you can slice and dice the markets
by apportioning some % for large companies and some % for small companies. In commodities,
you can buy gold/silver or buy commodity ETFs that invest in rolling the commodity options
in a wide variety of commodities.

2. Market Portfolio: Market portfolio is a theoretical portfolio in which every available
type of asset is included at a level proportional to its market value. Described as a group
of investments, a portfolio is owned by one individual or organization. The typical
investment portfolio may include a variety of assets, but usually does not include all asset
types. However, a market portfolio literally includes every asset that exists in the market.
The market value of an investment is described as its current price on the market. The term
is also used to refer to the amount for which an asset could presumably be resold. In a
market portfolio, investments are held in proportion to their market values in relation to
the full value of all included assets.

A market portfolio is a portfolio consisting of a weighted sum of every asset in the
market, with weights in the proportions that they exist in the market (with the necessary
assumption that these assets are infinitely divisible).
Richard Roll’s critique (1977) states that this is only a theoretical concept, as to create a
market portfolio for investment purposes in practice would necessarily include every
single possible available asset, including real estate, precious metals, stamp collections,

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