What Is The Market Portfolio—And How Should It Influence How We Invest? (EP.233)

0:28We all need to make smart decisions with our money. using that phrase as shorthand for something pretty simple. A total stock market index fund may be paired with a total bond market fund. If you own a broad U.S. stock index and a core bond fund, it's natural to feel like you own the market. And for the typical retirement portfolio, that's often close enough. But when we zoom out and think about asset allocation, questions like, should I invest in private equity? Or how much should I put in real estate or gold or even crypto, that casual definition stops being very helpful. In that setting, the market portfolio means something much bigger and more specific.

1:07The true market portfolio requires us to total up the value of every investable asset in the world, every publicly traded stock, every bond, listed real estate, private markets, gold, crypto. And if you visualize a simple pie chart where each asset gets a slice of the pie that matches its share of total value. That's how you arrive at the market cap weighting that asset allocators like myself think about when we're making decisions related to portfolio construction. I was recently told that I'm incorrectly assuming that everyone knows what market cap weighting means, so real quickly, the market cap of a stock is just its share price times the number of shares outstanding.

1:50And for an asset class like U.S. stocks, You simply add up all the market caps of the individual companies in that market. So if U.S. stocks make up a third of the total value of global investable assets, then they get roughly a one-third weight in a market portfolio. Whereas if crypto is about 1 % of that global pie, it gets about a 1 % weight. Now in past episodes, I've said that when you're thinking about adding something beyond public stocks and bonds, a good starting question is, what's this asset's weight in the global portfolio? So if an asset class is 1 % or 2 % of the world, and you're thinking about making it 20 % of your portfolio, that doesn't automatically make it wrong, but it should make you pause.

2:36It's just a way to gauge how far you're stepping away from the market portfolio. And recently, I came across a research paper from Goldman Sachs that takes the idea of the world portfolio and really fleshes it out. They look at what the global market portfolio holds today, how it's changed over time, and how it compares with simple portfolios, like a 60-40 mix of stocks and bonds. I'll link to the report in the show notes, but if you like this kind of deep dive, my newsletter is where I share reports like this one that we're going to be talking about today. In the newsletter, it goes out every other Wednesday, and I actually highlighted this Goldman Sachs piece there a few weeks ago.

3:14So if you want to stay on top of the research and information that matters for your portfolio and your financial plan, you can sign up using the link at the top of the episode description or by visiting thelongterminvestor.com. So here's where we're going to head in this episode. First, I will walk through what the investable world portfolio looks like today, the real pie chart of global assets. Then we're going to look at how that picture has shifted over time and why the market portfolio, that classic investing books had in mind isn't necessarily the same as today's version. And then finally, we'll talk about how to use this information when you're making decisions about things like international stocks, alternatives, or sticking with a simple stock and bond mix.

4:00Now, Goldman Sachs estimates that if you add up the value of all investable assets in the world, stocks, bonds, real estate, private markets, gold, and crypto, you end up somewhere around$260 trillion. The largest piece of the market portfolio belongs to U.S. stocks. It's about one-third of the pie. And for what it's worth, the S &P 500 represents about 80 % of the U.S. stock market, so that's a pretty large chunk of the market portfolio on its own. The next big slice is stocks outside the U.S. It's a bit smaller, it's just under a fifth of the total pie, and it includes developed markets like Europe and Japan, as well as emerging markets like India or Brazil.

4:40And then you have bonds. If you combine U.S. bonds and bonds issued outside the U.S., they add up to around 40 % of the world portfolio. So if you stopped right there and only looked at public stocks and bonds, you'd already have most of the global portfolio covered. After that, you move into what most people think of as alternatives. There's a mid-single-digit slice of gold. There's a very small slice of listed real estate like REITs. There's another small slice for private markets. That's private equity, private credit, similar vehicles. And then out there on the edge of the pie is a sliver for crypto, roughly 1%.

5:18So here is the picture I want you to create in your head. 86 % of the market portfolio is public stocks and bonds. And a noticeably large share of that equity exposure is in the US. And then there are thin wedges for gold, it's about 6%, real estate at 2%, private markets at 5%, and crypto at 1%. Now, right away, one thing jumps out at me. Most of the world's investable money is still in plain public markets. And so for all the headlines about private investments or crypto, those markets are still small compared with global stock and bond markets. And if you're thinking of putting 20 % of your money into private or alternative investments, or 10 % into gold, or 5 % into crypto, you are making a major deviation from the market portfolio.

6:07I think it's kind of interesting in the Goldman Research piece. It compares the world portfolio, this big diversified mix of every investable asset, to a basic 60-40 portfolio of global stocks and global bonds. And the comparison is made on a risk-adjusted basis. and it finds that the simple portfolio is superior. Now, risk-adjusted returns. This simply means that for the amount of up and down movement that you live through, did you get enough return in exchange? Because if two portfolios earn similar long-term returns, but one is much bumpier, the smoother one is better on a risk-adjusted basis.

6:44Meaning it gave you more return per unit of stress, and it also leads to better compounding of wealth. And so I think it's natural to wonder, well, why does a plain 60-40 look better than owning everything in its market cap weighting? One reason, I think, is that the world portfolio, those assets that aren't those public stocks and bonds, they just haven't consistently earned their keep. If you think about gold and certain pockets of private markets and other real assets that can be useful in specific environments, they haven't delivered strong, steady, long-term returns relative to their volatility.

7:19When they spike, their slice of the pie grows, but when they slump, it shrinks, and there's really no deliberate rebalancing across those pieces. A 60-40 portfolio, especially when compared this way, it does rebalance. So when stocks run ahead, they get trimmed, and when bonds lag, you add to them. And that simple discipline alone has historically smoothed the ride and in some periods, boosted risk-adjusted returns. Now, the world portfolio, yes, it's extremely diversified, but beyond a certain point, adding tiny slices of everything doesn't actually help all that much. And some assets just don't contribute enough return to justify the extra complexity and the noise they bring.

7:59And so, none of this makes the world portfolio irrelevant. It's still a very helpful reference point, but it does show you the actual global opportunity set and where the money really is. It's not a prescription. It's just a number. And just because an asset is owned by enough of the world that it shows up in this market portfolio pie chart doesn't mean that it deserves a big spot in yours. And if something's a tiny slice globally, you can still choose to overweight it. But I think what makes this all interesting is at least you'll know how far you're stretching. So, you know, I think this stands out to me mostly because this rebalanced 60-40 stock and bond portfolio has held up remarkably well over time, often better on a risk-adjusted basis than simply owning everything that was in the world portfolio itself.

8:45And that's not an argument that everyone must be 60-40, it's just an argument for starting with a straightforward, low-cost stock and bond core and then being deliberate when you step away from it. Now, the second thing that stands out to me when looking at the global market portfolio is the absolute dominance of the United States, something that we've talked about a number of Times recently on the show, if you look back at the global pie chart, the U.S. equity market isn't just the biggest slice. On its own, it's roughly two-thirds of the global stock market value, so more than all other stock markets combined.

9:19And when you add in the U.S. bonds, the American share of the overall world portfolio gets even larger. I think a lot of times we forget how we even got here, but a big part of the story is profitability. Over the past decade or more, U.S. companies, especially large technology and platform businesses, have out-earned much of the rest of the world. And so those stronger profits support higher valuations, and higher valuations translate into a bigger share of the global market cap. And market structure matters too. I mean, U.S. markets are deep and liquid, and if you are a global investor looking for innovation, rule of law, and functioning capital markets, the U.S.

9:59is an obvious place to allocate money. And over time, that preference shows up in the size of the U.S. slice. Now, that explains the past. I think the question that really matters, though, is what does this dominance mean going forward? And so one place to look is valuations. Again, a topic we've covered before. Many broad U.S. equity indexes today trade at forward price to earnings ratios in the low 20s, while broad international markets sit closer to the mid-teens. Now, that doesn't tell you what's going to happen next year, but it does tell you that the U.S. is priced for higher expectations.

10:30And historically, paying more means you should expect a bit less from future returns. And paying less means you don't need to have as much growth to have a decent outcome. There's also concentration risk in the U.S. When one country dominates your equity exposure the way the U.S. does, you're tying a lot of your financial future to a single economic system, a single policy regime, a single relatively narrow group of mega cap companies. Yes, you're diversified within the U.S., but not necessarily across the world. And again, this isn't a case for dumping U.S. stocks. It's a case for not letting your portfolio turn into an all-U.S.

11:08bet by accident. So if every equity fund you own has U.S. in the name, you're effectively saying, I think the next decade will look a lot like the last one. Maybe it will, maybe it won't, but either way, that's a big statement to make without meaning to. From a valuation, diversification, and risk management perspective, there's a strong argument for owning a real slice of non-US stocks, not just some token amount that disappears on your statement, but something you can point to and say, if leadership broadens out, this will actually move the needle. One last thing I want to point out about Goldman Sachs' report is that they rebuild what the portfolio would have looked like in earlier decades so that you can see how different eras reshape the mix of global assets.

11:52So they build this 1950 onward version with just global stocks, bonds, and golds, and then this 1990 onward version that adds things like listed real estate, credit, private markets, and eventually crypto. And there really are great visuals in the report. So again, you can find those in the show notes at thelongterminvestor.com. I think what stands out for me is that when classic investing books talk about the market portfolio, they're talking about that earlier world with far fewer moving parts than we have today. No crypto, no small private markets industry, less sovereign debt, none of the alternative categories that get so much attention now.

12:31And I want to say, I think the theory from that era still holds, but I do think it's worth noting how the ingredients have changed. And I think the biggest implication for me personally is my viewpoint on how we define the best type of investments. I'm going to touch on this a little bit later, but I felt like I needed to call that out before we move on. So what do you actually do with your own portfolio in light of this information? I think we've called out you don't have to own everything to be well diversified. The world portfolio shows you what exists and how big each piece is, but your job is to build something you can actually live with.

13:06For most investors, a very solid starting point is a simple global stock and bond core. So in practice, that might be a couple low-cost funds that track broad market indices, you might dial up the split between stocks and bonds depending on your age, your risk tolerance, your spending needs. So I earlier referenced a 60-40 portfolio, but maybe you're a 70-30 or an 80-20 or 50-50. The exact numbers matter less than picking a mix that fits and really just sticking with it. Now that kind of portfolio already lines up pretty well with the main lesson from the Goldman research, which is that a clean rebalanced stock and bond mix has held up very well over time.

13:46The world portfolio, in my point of view, comes in as a reality check, not a rulebook. And so when you think about adding something beyond public stocks and bonds, you can ask yourself, what's its rough weight in the global market portfolio? And how far am I planning to deviate from that? And why? I think crypto is a good example. It's something I've referenced on the show in the past in the context of the market portfolio. And so if crypto is roughly 1 % of the world portfolio and you're tempted to make it 10 % of your portfolio, or even something like private markets, which are just a small wedge globally, but you're eyeing a 20 % allocation, neither of those things are automatically wrong, but it should give you some pause and you're making a very different choice than the world portfolio as a whole.

14:28And you want that reason that you're making the choice to be grounded in solid evidence. I think in general, the world portfolio helps as a backdrop, and it reminds you that public stocks and bonds are still the main event, and that the U.S. isn't the whole world, and that alternatives are smaller than marketing would have you to believe. And so from there, your job is not to fine-tune every slice. Your job is to build something understandable, diversified, and affordable, and most importantly, something you can stick with for a long time. Now, hopefully you can tell my goal today isn't to turn you into a world portfolio purist.

15:05I think it is really just to give you a reference point so you can see how big public markets really are, how dominant the U.S. has become, and how far you're stretching when you're loading up on things like private markets, gold, and crypto. Now, I mentioned before that classic investment theory still holds despite the changes to the global market portfolio. But next week, I want to think a little bit more about a question that stems from that. So if the market cap weighted portfolio is the baseline, what does it mean to step away from it on purpose? And to me, a really interesting component of that is where does factor investing come in relative to index investing?

15:43So in the next episode, I'm going to talk about the difference between index investing, which is basically owning the market portfolio is defined by market caps. And factor investing, where you use rules to tilt your portfolio toward things other than market cap alone. So if today's episode was about understanding the world's default setting, the next one is about how and why you might adjust that default in a thoughtful way. And if you want to see some of the charts and research that sit behind episodes like this, again, make sure you're signed up for my newsletter. There's a link at the top of the episode description.

16:16It comes out every other Wednesday, and it's where I share links, visuals, and follow-ups that don't always make it into the podcast. As always, thanks for listening and until next time to Long-Term Investing.

16:53This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.