CFDP 1154

The Significance of the Market Portfolio

Author(s): 

Publication Date: June 1997

Pages: 32

Abstract: 

The market portfolio (world portfolio) is in one sense a least important portfolio to provide to investors; there is always a better portfolio for social planners to make available to them. In a J-agent one-period stochastic endowment economy, where preferences are quadratic, the market portfolio is never spanned by the optimal markets a social planner would create. With identical preferences, the market portfolio is orthogonal to all J - 1 portfolios which achieve a first best solution. These conclusions rely on the assumption that the social planner has perfect information about agents’ utilities. We also show that as the contract designer’s information about agents’ utilities becomes more imperfect, the optimal contracts approach contracts that weight individual endowments in proportion to elements of eigenvectors of the variance matrix of endowments. If there is a substantial market component to endowments than a social planner, for reasons of robustness and simplicity, may conclude that creating a contract to allow trading the market portfolio would be a significant innovation.

See CFP: 997