The Passive Strategy Is Efficient

A passive strategy, using the CML as the optimal CAL, is a powerful alternative to an active strategy. The market portfolio proportions are a result of profit-oriented "buy" and "sell" orders that cease only when there is no more profit to be made. And in the simple world of the CAPM, all investors use precious resources in security analysis. A passive investor who takes a free ride by simply investing in the market portfolio benefits from the efficiency of that portfolio. In fact, an active investor who chooses any other portfolio will end on a CAL that is less efficient than the CML used by passive investors.

We sometimes call this result a mutual fund theorem because it implies that only one mutual fund of risky assets—the market portfolio—is sufficient to satisfy the investment demands of all investors. The mutual fund theorem is another incarnation of the separation property discussed in Chapter 6. Assuming all investors choose to hold a market index mutual fund, we can separate portfolio selection into two components: (1) a technical side, in which an efficient mutual fund is created by professional management; and (2) a personal side, in which an investor's risk aversion determines the allocation of the complete portfolio between the mutual fund and the risk-free asset. Here, all investors agree that the mutual fund they would like to hold is the market portfolio.

While different investment managers do create risky portfolios that differ from the market index, we attribute this in part to the use of different estimates of risk and expected return. Still, a passive investor may view the market index as a reasonable first approximation to an efficient risky portfolio.

The logical inconsistency of the CAPM is this: If a passive strategy is costless and efficient, why would anyone follow an active strategy? But if no one does any security analysis, what brings about the efficiency of the market portfolio?

We have acknowledged from the outset that the CAPM simplifies the real world in its search for a tractable solution. Its applicability to the real world depends on whether its predictions are accurate enough. The model's use is some indication that its predictions are reasonable. We discuss this issue in Section 7.4 and in greater depth in Chapter 8.

1. If only some investors perform security analysis while all others hold the market portfolio (M), would the CML still be the efficient CAL for investors who do not engage in security analysis? Explain.

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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