Security Market Line (SML) and Capital Market Line (CML)

Security Market Line (SML)

According to Brearley (2012), the SML represents the CAPM equation and implies a linear connection between the expected return and systematic risk (beta). The SML intercept on the Y-axis (expected returns) represents the risk free rate when beta equals to 0. CAPM states that the market portfolio is efficient, thus all stocks should lie on the SML (Berk, 2011). Shares should be bought if the security is plotted above the SML as it is undervalued and investors can expect greater takings. Vice versa, the stock should be sold if it is plotted below the line as it means it is overvalued and the returns are not enough to compensate for the risk. This will push back the market to equilibrium.

Capital Market Line (CML)

The CML represents the best possible group of portfolio assets that makes the most out of the expected level of returns at a  given level of risk (as defined by volatility/ standard deviation). Thus, investors should choose a portfolio with a combination of both risk free investments and market portfolio (RiskLearn, 2012). It is noted that when investors have identical expectations the market portfolio and efficient frontier coincides (JM Samuels, 1995:258-262). This is known as the tangency portfolio.