What it means
The line plots expected return on the vertical axis against beta on the horizontal axis. Beta measures how strongly an investment's returns move with the overall market, so a beta of 1 means it moves in step with the market and a beta above 1 means it swings more.
The line starts at the risk-free rate (the return on a very safe investment such as a short-term government bill) and slopes upward. The slope of the line is the market risk premium, which is the extra return that investors demand for holding the market instead of the risk-free asset.
A higher beta therefore earns a higher required return. An investment with a beta of zero should earn just the risk-free rate.
The useful part is the comparison, because an investment whose expected return plots above the line offers more than the model says its risk deserves and appears undervalued. One that plots below the line looks overpriced for its risk.
The gap between the two is often called alpha. Corporate finance teams use the same line to estimate the cost of equity, which is the return shareholders require from the company.
That figure becomes an input to the discount rate used in project appraisal and valuation. Choosing the risk-free rate, beta and market premium carefully matters, because small changes move the answer a lot.
There are limits. The model assumes beta is the only risk that is rewarded, and real markets show other patterns such as size and value effects.
Betas are estimated from past data and can change, so the SML is best treated as a disciplined starting point and not a precise prediction. It also helps to remember what the line leaves out.
Company-specific risks, such as a failed product or a lawsuit, can be reduced by diversification, which is why the model rewards only the market-related part of risk.
In practice
Real-world examples.
Example
A portfolio manager compares three shares against the line. Two plot close to it, while the third offers 1.5 percentage points more than its beta justifies. She investigates why the market might be undervaluing it before buying.
Example
A corporate finance team needs a cost of equity for a new division. Using a risk-free rate of 4%, a market premium of 6% and a beta of 1.0 from similar companies, it calculates 10%. The team uses that rate to discount the project's cash flows.
Example
A financial adviser explains to a client why a speculative technology holding must offer a much higher expected return than a utility. He draws the line and marks both shares, showing that the higher beta demands a higher return. The client understands why the portfolio has lower expected returns when risk is reduced.
Formula
Calculation
Expected return = Risk-free rate + Beta x (Market return - Risk-free rate)
Suppose the risk-free rate is 4%, the expected market return is 10%, and a share has a beta of 1.2. The market risk premium = 10% - 4% = 6%. Expected return = 4% + 1.2 x 6% = 4% + 7.2% = 11.2%. If analysts forecast that the share will actually return 12%, it plots above the line by 12% - 11.2% = 0.8 percentage points, which suggests it is modestly undervalued.Case study
Seen in the real world.
Harrow and Lane is an illustrative, fictional investment boutique that applied the security market line to a client's portfolio of ten shares. The analyst estimated the beta and expected return for each holding.
Seven of the ten plotted near the line, but one with a beta of 1.4 sat well below it, offering a forecast return of only 8% when the line implied about 12.4%. The firm concluded that the client was taking above-average risk without being paid for it.
The client sold the holding and moved the money into a broad index fund. The illustrative lesson is that the line is a useful screen for finding investments where risk and reward appear out of balance.
Watch out
Common mistakes.
- Confusing the security market line with the capital market line, which plots return against total risk for efficient portfolios.
- Using an out-of-date or poorly estimated beta, which can make an investment look cheap or expensive when it is not.
- Treating the result as a certainty, when the line is a model based on assumptions about markets and investors.
Questions
People also ask.
What does it mean if a stock plots above the line?
Its expected return is higher than the model requires for its beta, so it may be undervalued.
What is the slope of the line?
It equals the market risk premium, the market return minus the risk-free rate.
Is the SML the same as CAPM?
The SML is a graph of the capital asset pricing model, which supplies the equation behind it.
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