The Passive Strategy Is Efficient

In Chapter 7 we defined the CML (capital market line) as the CAL (capital allocation line) that is constructed from a money market account (or T-bills) and the market portfolio. Perhaps now you can fully appreciate why the CML is an interesting CAL. In the simple world of the CAPM, M is the optimal tangency portfolio on the efficient frontier, as shown in Figure 9.4.

In this scenario the market portfolio that all investors hold is based on the common input list, thereby incorporating all relevant information about the universe of securities. This means that investors can skip the trouble of doing specific analysis and obtain an efficient portfolio simply by holding the market portfolio. (Of course, if everyone were to follow this strategy, no one would perform security analysis and this result would no longer hold. We discuss this issue in greater depth in Chapter 12 on market efficiency.)

Thus the passive strategy of investing in a market index portfolio is efficient. For this reason, we sometimes call this result a mutual fund theorem. The mutual fund theorem is another incarnation of the separation property discussed in Chapter 8. Assuming that all investors choose to hold a market index mutual fund, we can separate portfolio selection into

CHAPTER 9 The Capital Asset Pricing Model

two components—a technological problem, creation of mutual funds by professional man-agers—and a personal problem that depends on an investor's risk aversion, allocation of the complete portfolio between the mutual fund and risk-free assets.

In reality, different investment managers do create risky portfolios that differ from the market index. We attribute this in part to the use of different input lists in the formation of the optimal risky portfolio. Nevertheless, the practical significance of the mutual fund theorem is that a passive investor may view the market index as a reasonable first approximation to an efficient risky portfolio.

CONCEPT CHECK ^ QUESTION 1

If there are only a few investors who perform security analysis, and all others hold the market portfolio, M, would the CML still be the efficient CAL for investors who do not engage in security analysis? Why or why not?

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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