The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta.

The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line.

Figure 17.1: Security Market Line



Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium required by investors was to change, the slope of the SML would change as well.

When a shift in the SML occurs, a change that affects all investments' risk versus return profile has occurred. A shift of the SML can occur with changes in the following:

  1. Expected real growth in the economy.
  2. Capital market conditions.
  3. Expected inflation rate.


The Portfolio Management Process

Related Articles
  1. Managing Wealth

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  2. Managing Wealth

    Understanding Market Risk Premium

    Market risk premium is equal to the expected return on an investment minus the risk-free rate. The risk-free rate is the minimum rate investors could expect to receive on an investment if it ...
  3. Managing Wealth

    How to Calculate Risk Premium

    Think of a risk premium as a form of hazard pay for risky investments.
  4. Managing Wealth

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
  5. Investing

    Calculating the Equity Risk Premium

    Equity risk premium is the excess expected return of a stock, or the stock market as a whole, over the risk-free rate.
  6. Managing Wealth

    What Investors Should Know About Interest Rates

    Understanding interest rates helps you answer the fundamental question of where to put your money.
  7. Managing Wealth

    Determining Risk And The Risk Pyramid

    Many investors do not understand how to determine the risk level their individual portfolios should bear.
  8. Managing Wealth

    Why Risk-Free Investments Don't Exist

    We explain the risks inherent with all types of investments and why risk-free investments do not exist.
  9. Managing Wealth

    Understanding Market Risk

    Market risk is the chance that an investment’s value will decrease due to a factor that affects all investments across the market.
  10. Managing Wealth

    Systematic Risk

    Systematic risk, also known as volatility, non-diversifiable risk or market risk, is the risk everyone assumes when investing in a market. Think of it as the overall, aggregate risk that comes ...
Trading Center