Roll's Critique

An economic idea that suggests that it is impossible to create or observe a truly diversified market portfolio (one of the key variables of the capital asset pricing model (CAPM)). According to this view, a true "market portfolio" would include every investment in every market, including commodities, collectibles and virtually anything with marketable value. Those who still use the CAPM do so with a market index, such as the S&P 500, as a proxy for the overall market. The critique is attributed to economist Richard Roll.

The equations that make up the CAPM are highly sensitive to the initial variables. A small change in the market rate of return (as it is entered in the formula) can have a large impact on the solution set. The CAPM presents a solid framework for adding an investment to a diversified portfolio, but due to Roll's critique and others, many researchers have expanded to different models. Roll's critique reminds us of the important fact that we can only diversify so much, and that our attempts to know the market as a whole remain just that - attempts.