Fig 7 The Security Market Line.
It is obvious that higher the value of beta, higher would be the risk of the security and
therefore larger would be the return expected by the investors. The beta coefficient of the
market portfolio by definition is 1. The line joining points (rf 0) and Rm’ 1) in Fig 7 is the
security market line (SML).
A major implication of CAPM is that not only every security but all portfolios too must
plot on SML. This implies that in an efficient market, all securities are expected to yield
returns commensurate with their riskiness, measured by ß.
CML and SML
It is interesting to contrast CML with SML. Both postulate a linear (straight line)
relationship between risk and return. In CML, the risk is defined by the total risk (s),
while, in SML, the risk is defined by the undiversifiable market related risk (ß). Capital
Market Line is valid only for fully diversified (efficient) portfolios while SML was valid
for all portfolios and for individual securities as well.
Beta
We have discussed the distinction between diversifiable risk and non-diversifiable risk at
such length because from the point of view of an investor whose portfolio is well
diversified, the diversifiable risk is of no importance as it has been eliminated. What is
important to such an investor is the non-diversifiable risk arising from market wide
movements of security prices. This is one of the most important conclusions of the MPT:
the real riskiness of a security is its non-diversifiable risk.