Most times in market, reward correspond risk; but the risk-to-reward ratio differs with different instruments. So it is possible to find instruments which are undervalued (have slightly lower risk) which can offer better rewards; and SML is the tool for that. Security Market Line or SML is a very useful tool for stock screening, optimizing portfolio risk and return, and for finding undervalued instruments. SML, which is also known as Characteristic Line, is an application of Capital Asset Pricing Model or CAPM which is used to find risk associated with an investment.
To better understand security market line, one should understand CAPM. CAPM is one of the most widely used (value) investment model, which shows the risk and return associated with an instrument. The formula is simple.
R = Rf + beta x (Rm – Rf)
Where R is the return, Rf is return from risk-free investment, beta is the beta value (risk or volatility) associated with an instrument and Rm is the expected return from market (an average value). Investments can be done on instruments whose return equal or exceed the expected return from market. Thus with CAPM, an investor can carefully choose instruments to get a specific return at lowest possible risk OR he/she can adjust portfolio investments to a certain risk level.
Security market line simplifies all these things. SML is a straight sloppy line which shows the expected return from market (the Rm value) for a specific level of risk. The risk or beta value of market is plotted on the X axis of the graph and expected market return is plotted on Y axis. SML starts from the Rf value (rate of risk free investments), which runs parallel to the X axis.
Now with this simple set up investors can test expected return from various instruments with respect to the risk of trading the instrument. Instruments which fall above the security market line tend to offer better reward for a risk level.
Fore example if the risk free ratio is 3%, market beta is 3 and expected market return is 8%, then the SML line will originate from 3 (at Y-axis) and will have a return of 3+3(8-3) = 18%. Now any instrument whose beta is 3 and the expected return of which is above 18% can be good for investing. If the expected return is below 18%, it is considered as an over-valued investment.
Remember strategies like CAPM and SML works mainly for long-term trading and investing; and it is hard to employ them in short-term trading. No one is capable of predicting the exact future and market return and thus long-periods of volatility and sidewise movements can challenge the returns.
