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The Security Market Line: Definition & Uses

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  • 0:04 Risk and Investing
  • 0:45 Security Market Line
  • 1:39 Beta and the SML
  • 2:33 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How do you evaluate an asset's risk profile compared to the market as a whole? In this lesson, we'll examine what beta is and how the security market line (or SML) can help investors compare the risk of a specific asset to that of the market.

Risk and Investing

Rita is in charge of an investment portfolio for her company's pension plan. That's a lot of pressure! Rita wants to make sure that the things she invests in are making her company money but also that they aren't too risky.

There's always risk in investing, but some assets are riskier than others. Ideally, the higher the risk, the higher the possible return will be. But for people like Rita, sometimes high risk and high reward aren't what they want. What if Rita wants assets that will be close to the overall market when it comes to risk and reward?

To help Rita figure out whether the equities she's invested in are in line with the market overall or if they are riskier, take a look at the security market line and beta.

Security Market Line

Rita wants the investments she makes for her company to be in line with the market, not riskier or less risky. But what happens when she is faced with a specific equity? How does she evaluate it?

To understand the risk of a specific equity, some people compare it to the security market line, or SML. This is a graphed line that represents the relationship between expected returns (what an investment will likely earn) and an asset's covariance with the market returns (what it will do in comparison to the market).

SML

If that sounds confusing, look at the SML image. When we look at the SML, we can see that the higher the risk is, the higher the expected returns are. A really risky equity will be far over to the right side of the graph. Its expected return is very high up.

The SML line helps show how equities that are average will work. If a specific equity falls on the line, it means that the asset is right in line with the market as a whole.

Beta and the SML

That's all well and good, but how can Rita know if her asset is risky or not?

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