The Significance of the Market Portfolio

Arguments for creating a market to allow trading the portfolio of all endowments in the entire world, the "market portfolio," are considered. This world share market would represent a radical innovation, since at the present time only a small fraction of world endowments are traded. Using a stochastic endowment economy where preferences are mean variance, it is shown that creating such a market may be justified in terms of its contribution to social welfare. It is also argued that creating a market for world shares is attractive for certain reasons of robustness and simplicity. The portfolio of all endowments in the world, the "world portfolio" or, more commonly, the "market portfolio," has great significance in the capital asset pricing model (CAPM) in finance.1 The Sharpe-Lintner CAPM characteriza- tion of optimal risk sharing implies that in equilibrium no one will be subject to a random shock that is not shared by everyone else. Thus the CAPM gives us the "mutual fund theorem," which asserts that only one risky portfolio need be available to individual investors, the mutual fund that holds shares in the world portfolio. In this article we seek further clarification of the significance of the world portfolio beyond the bounds of the restrictive assumptions of the CAPM. The original version of the CAPM was designed to describe how agents should invest in existing financial assets.2 Thus all agents have some stock of wealth and they must choose how much of their wealth to invest in each asset. There is some zero-cost intermediary that allows the agents to purchase the assets. One of the key insights of the CAPM is that each agent needs only the shares in the world portfolio and the risk-free bond to be available to them to trade in so that they obtain their optimal allocation of risk. It is in this sense that the world portfolio is so important in the CAPM. In our analysis we will drop the (highly unrealistic) assumptions of the CAPM that all risks are tradable and that all agents have some nonstochastic