Security Market Line - SML
Ok, let’s start with the basic formula for SML, which is just the beta of a given stock divided by the beta of the overall market. If you haven't seen our Scorsese directed opus on Beta, well, then, you should. And click on the ads, the guy doesn’t work for free, you know.
The SML is just a graph depicting the risk or volatility adjusted investment returns inside of the capital asset pricing model structure. Overly simply, investment opportunities living up here, above the SML, are probably, at least according to this line...undervalued; and securities living below this line are overvalued.
The line itself is sort of fairness. Or where everything is fairly priced relative to its risk, or beta, and its reward, or...um...reward. The assessment of risk here is the hard part. That’s risk, or beta, and the quick n’ G-rated dirty on beta is that a stock with a beta of 1 moves in about the same direction and amount as the overall market in which it lives.
Think: like a tech stock like Oracle...inside of the market of, say, NASDAQ. On any given day, the market might be up 1 percent. If so, then if Oracle is displaying a beta of 1, then it too will be up 1 percent. And vice versa.
A stock with a beta of 2 will move twice as much as the market, i.e., on a down 1.5 percent day for the market, that stock should be down 3 percent. Notionally, beta is another word for risk, and higher beta stocks imply that they are more risky. But that’s a really narrow view, because over time, the market itself goes up.
Like, look at this beautiful century-ish of stock prices of the S&P 500. Yeah. UP. (Not the movie.) So when someone claims that a stock is riskier because it has higher beta, that may be true in the short run. But in the long run, higher beta stocks moving more than the market, as a basket, do better than the market.
Why do we point this out?
Because this model...doesn’t work. At least not for real investors actually trying to invest. Real time. The model is a reflection of what happened in the past sort of like driving while looking in the rear view mirror.
You see miles of road behind you, as you head out on the highway, looking for investing adventure. All is good. Until it’s not.