What is the security market line?

The security market line visually represents the capital asset pricing model (CAPM). It depicts the relationship between the expected returns of an investment and the level of risk associated with the investment. In a more accurate representation, the security market line plots a representation of the expected returns from marketable security at a level of risk determined by the beta of the security against the market. This calculation, however, does not account for idiosyncratic risks.

The security market line, also known as the “characteristic line” is a graphical representation of the CAPM in which the X-axis represents the risk associated with the security whereas the Y-axis represents the level of expected returns. The primary function of the security market line is to determine whether an investment in security would offer a favourable return against the level of risk associated with the security. The formula for the security market line is:

Required return = Risk-free rate of return + beta (market return - risk-free rate of return)

The beta is a non-diversifiable or systematic risk that is central to the concept of a CAPM (capital asset pricing model) or SML (security market line).

This risk is also known as market-risk or volatility and is a risk associated with the entire market, not just a particular type, segment or security.

An example of such risk can be those due to war-like situations, geo-political issues, health crises and more, things that we have experienced recently. A beta value of one can indicate a risk level equivalent to the current market average level of risk. However, a beta value greater than one indicates a greater level of risk than the current market average and the value less than one represents a risk level lower than the current market average.

The value of beta is most often directly associated with the level of expected return from a security. Therefore, if the beta value is higher than the market average (risk in that particular security is higher than the market average) the expected returns may also be higher than what’s expected of the market average and vice versa.

Besides determining the favorability of investment in one security, a security market line can also accurately depict the condition of a stock's valuation or price i.e. whether a particular commodity is overpriced or underpriced. As a graphical representation, if an asset offers a rate of return lower than the market average it is plotted below the SML whereas if it offers a rate of return higher than the market average it is plotted above the SML.

If an asset is plotted below the security market line it is overpriced and vice versa. The reason behind it is that the asset is giving a return lower than the market average due to the cost of buying the asset being too large. Since the return on an asset is directly proportional to the price of the asset - this means the asset is overpriced and must be reduced in price to re-approach the market average.

How to use the security market line?

A security market line is a tool of evaluation often used by individual investors or money managers that are scrutinizing stocks to add into their portfolio based on their degree of favorability. The security market line tells them whether a stock is giving adequate returns compared to the amount of risk associated with it.

When a stock is plotted above the SML it is undervalued because the level of returns are higher than the risk and when plotted below the SML it is overvalued because the level of returns doesn’t justify the risk. The graphical representation of this risk-reward relationship on a security market line is what allows traders to make accurate portfolio addition decisions.

Security market line assumptions

The SML is a graphical representation of the CAPM. Therefore, all the assumptions that are held for CAPM are also held for SML out of which the most common assumption revolves around CAPM being a one-factor model that only accounts for the systematic risk that exposes a security.

Another assumption is that the risk-reward relationship is linear. Thus, the greater the risk the greater the reward. Although this is most often true, it may not always be the case. Along with these assumptions, here are a few more assumptions of the security market line:

• The investment horizon for all investors is the same
• There are no short sales
• There’s only one risk-free asset whilst there are multiple risky assets
• All market participants are rational
• There are no taxes or transaction cost
• Market participants are all price takers and they cannot affect the price of a security.

Final Words

The security market line depicts the relationship between the expected returns of a particular investment and the risk involved. It is used by individual investors or money managers to add favourable stocks to their portfolios. If you have a few favourable stocks in mind just like these investors, open a Demat account with IIFL today and start investing in stocks through your research using an SML or check out our hot stock picks to guide your investing decisions.