Kar Yung's post

The Market Portfolio and the Average Investor

The market portfolio is often presented by people like Eugene Fama as the best starting point for most investors. It simply holds what the market holds, so you are not forming an opinion about which assets should be overweight or underweight.
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It is also sometimes described as the right portfolio for the average investor. But no one is actually the average investor.
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The average investor is a mysterious figure who exists only on paper. You create them by grabbing a piece of every investor and combining all those pieces into one person. They have some of everyone’s labor income, housing, liabilities, taxes, constraints, time horizons, and concerns.
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By construction, this person holds the market portfolio because their portfolio is everyone’s portfolio combined. But no actual investor is this person.
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I had a conversation with Ben Felix about this years ago in the context of gold. Ben said they did not hold gold, and I asked whether that conflicted with the idea that the average investor should hold the market portfolio.
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His answer was that the average investor theoretically holds gold, but that does not mean any particular individual should.
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I then asked whether this meant someone else, or some group of people, had to be overweight gold. After all, everyone’s portfolios still have to combine back into the market portfolio.
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Ben said yes, but it may be more rational for those other investors to hold it. One example he gave was that a big part of gold’s expected return comes from the gold lending market, which retail investors generally do not participate in.
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The conclusion I draw from this is not that deviating from market weights is automatically better. The fact that nobody is the average investor does not make every individual portfolio tilt rational.
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The narrower point is that the market portfolio cannot be assumed to be uniquely optimal for every person. A deviation may be optimal when it follows from a real difference between an investor and the aggregate market, such as their labor income, housing, liabilities, taxes, spending currency, investment access, or exposure to specific risks.
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You can think about home bias in a similar way. Investors in different countries can each hold somewhat more of their own market while their portfolios still combine back into the global market portfolio.
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But the fact that those home biases add up does not prove that they are sensible. Market clearing explains how different portfolios can coexist. It does not tell us whether a particular investor has a good reason for deviating.
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This is why the market portfolio remains such a strong starting point. It is cheap, diversified, and requires very few assumptions. Once you move away from it, the burden is on you to explain what is different about your circumstances and why that difference should affect your portfolio.
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The market portfolio tells us what everyone holds together. It does not necessarily tell any one of us exactly what to hold.

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20 Comments

Bowen Chen

@investingsamoyed · 8d

I bought CAGX Instead 😬finally on that world ETF train

Mr Financial

@mr.financial · 8d

Since this platform is mainly Canadians and Americans , you can really see the results of what tilting looks like for a specific geographic area.

Kyle Garrett

@kgcottawa · 8d

I’m often disappointed in the majority of financial doscussions writ large, as so much nuance is lost. I live in the world of nuance.

Raj @double_oh · 8d

Ok this really resonates with me.

Every time I hear a talking head say "just buy a market index" this "no investor is average" nags at the back of my mind.

Tilting is really hard to avoid.
I think it's better to understand your deviation from the average and make sure you're ok with it.

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