Course: Investment Planning
Lesson 13: Asset Allocation

Student Question:

Hi,

Could you help me better understand the difference between the capital market line (CML) and security market line (SML)?  I can’t seem to fully grasp the difference.

Thanks,

Meg


Instructor Response:

Hi Meg,

First, let’s take a full step back for perspective.  The SML and CML are implications of the Capital Asset Pricing Model (CAPM).  The CAPM, in turn, expresses the theory that investors will always seek:

  • The highest level of return for a given level of acceptable risk, or 
  • The lowest level of risk for a desired return.

CAPM is used to make buy/sell/hold decisions in a portfolio.  For example, I will only buy stocks that provide at least the minimum expected return for a specific level of risk.  If projected returns for the potential investment do not meet my risk/return expectations, I will not buy the security.

With that in mind, three key differences between CML and SML follow:

Risk Proxy (Measurement) 

  • Standard deviation is the risk measure in the CML 
  • Beta is the risk measure in the SML 

Reliability

  • CML is always a reliable measure of risk because standard deviation measures all investment risk (systematic and nonsystematic)
  • SML is reliable for only highly diversified portfolios – beta measures only systematic risk 

Portfolio Vs Stock

  • CML determines risk or return for efficient portfolios
  • SML determines risk or return for individual stock

Onward and Upward,

Bruce