The security market line, also known as SML and referred to as the characteristic line, is the graph of a risk-return line. The line, which is a product of the capital asset pricing model (CAPM), graphs the relationship between market risk and expected return. Analysts use it to compare investment returns against different portfolios. Specifically, the line helps analysts discern what a reasonable level of risk is against a certain level of return. It is commonly used by portfolio managers looking for additional assets to add to the portfolio.
Investors typically want two things from an asset — no risk and lots of return — but that combination is difficult to find. As such, portfolio managers use tools to help them determine the best prices for assets. The security market line is a visual tool that helps managers and analysts determine whether or not an asset is over- or under-valued in the market, which ultimately leads to better decision making and a more profitable portfolio.
The CAPM is used to determine the return for a particular asset. The formula is Ks = Krf + B (Km - Krf), where Ks is the rate of return for a given security, Krf is the risk-free rate of return, Km is the average market rate of return, and B is beta. Beta represents non-diversified risk; that is, the risk that cannot be diversified away by owning a portfolio of stocks. Based on beta, the security market line begins with the risk-free rate, or zero risk, and moves up and to the right. A low-risk investment is located at the beginning of the line, so the higher an investment is on the line, the riskier the security.
If the line for an individual security is above the portfolio security market line, it indicates the stock is undervalued. If the stock is plotted below it, it means the stock is overvalued. In the former case, the investor can expect a greater return given the level of risk; in the latter case, the investor can expect to earn less return than comparable securities with the same level of risk. In other words, the SML helps portfolio managers determine the optimal level of return given a certain level of risk. It can also change due to macro-economic factors such as growth in the economy, changes in global capital market conditions and inflation.