Course: Investment Planning
Lesson 13: Asset Allocation
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.
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
- 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,