Portfolio Management - Capital Market Line (CML)
Figure 12.1 below shows why it is called the security market line:
Figure 12.1 illustrates:
- how a static, risk-free investment should yield the RFR,
- how an investment that varies constantly in direct proportion to the market (and thus has a covariance equal to the variance of the market) should yield the market rate, and
- how one particular investment that moves with greater volatility than the market (and thus has a higher covariance) ought to yield a higher return.
Given a beta, a risk-free rate, a market rate, fresh graph paper and neat handwriting, you should be able to draw a graph allowing you to eyeball a corresponding expected rate of return for an investment.
Incidentally, the slope of the SML line is equal to beta. The RFR is sometimes called alpha (α), which is defined as the measure of a stock's performance beyond what its beta would predict.
Read more about the advantages and disadvantages of Beta in the article Beta - Know the Risk.
The Capital Market Line
The SML figure is sometimes called the capital market line (CML) when it is used to illustrate a portfolio instead of a single investment.
- The takeaway message from the CML is that, for any given variance, the rational investor will always choose the portfolios that will give her the greatest possible return.
- Investing in any portfolio above the line is too risky compared to investing in other arrays of securities with the same expected yield; investing in anything below the line means leaving money on the table.
- The CML is a proxy for the efficient frontier, the line along which every rational portfolio lies.
The real question, then, is where does each of your clients belong on the graph above? Those in the accumulation phase should probably be closer to the right, while those who have reached the spending phase will want to be over to the left. The way to properly position an individual client's portfolio along the CML is through asset allocation, the process of deciding how to distribute an investor's capital for investment purposes.
These distributions can be done according to the following categories:
- geography, that is, by region within a country, or by countries around the globe;
- asset class, that is, a certain percentage in stocks, another in bonds;
- risk profile, that is, whether the investment is speculative, defensive or growth-oriented; or
- industry, that is, some percentage in technology, another in retail, another in government.
As a registered representative, you will need to develop an investment policy for each client that will specify how assets will be allocated in the portfolio. You will also need to revisit that policy every year, if not more often.
The following articles discuss the various strategies to minimize risk while maximizing return: