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It takes more than just keeping track of stock prices and planning your entrance or exit to invest in the stock market or trade short-term price changes. You need to go beyond the prices and take advantage of the risk-reward ratio if you want to develop into a skilled and active trader who can take advantage of the possibilities on the stock market. Many traders and investors frequently undervalue the significance of the risk-reward ratio. If you are also prone to doing this, you should be aware that it might wind up costing you money since you can end up taking too much risk for a small gain or not enough risk for a large reward that could pay off nicely. If you are interested in understanding the risk-reward profile of a stock, the Security Market Line (SML) is an essential concept for you. Read on to know about the definition of the Security Market Line, how it is calculated for charting purposes and its advantages and limitations.
The meaning of the security market line can be explained in simple terms as follows. It is a graphical line that shows you the relationship between the expected returns from a stock or investment, and the risks associated with that asset. Also known as the characteristic line, it is a graphical representation of the Capital Asset Pricing Model (CAPM).
The x-axis or the horizontal axis represents the risk of the asset or its beta, while the y-axis or the vertical axis represents expected returns from the asset. By plotting the security market line, you can get a better idea of the relationship between the risk and the expected returns from a stock, making it easier to assess if the risk is worth the expected returns.
Like every graphical line, the security market line is also governed by an equation that connects the two parameters used to plot it — namely the risk and the expected reward. The SML equation is as follows:
E(Ri) = Rf + βi [E(Rm) — Rf] |
Here, the parameters used in the above equation mean the following:
A more understandable version of this formula would be as follows:
Expected rate of return = Risk-free rate of return + Beta (Market Return — Risk-free rate of return) OR Expected rate of return = Risk-free rate of return + (Beta x Risk Premium) |
When you represent this equation in the form of a graph, you get the security market line.
Also Read: Difference Between SML and CML
The beta used in the security market line equation represents the risk associated with the asset, as mentioned above. It is one of the most crucial aspects of plotting the SML and assessing the risk-reward profile of a stock or asset.
To be more specific, the beta measures the systematic or non-diversifiable risk — which stems from the market itself and is inherent to the stock or asset in question. Based on the value of beta, you can assess how risky a stock is in comparison with the market. Here’s how:
Also Read: Risk Management In Stock Market
Now that you know the meaning of the SML and the equation used to plot it, let’s take a closer look at the key characteristics of the SML, so you can interpret it better.
Like every graphical technical indicator, the SML also has its own advantages and limitations. Let’s take a closer look at both these aspects for a comprehensive understanding of the SML.
Additional Read: What is PE Ratio?
Given the upsides and limitations of the SML, it is best to use it in conjunction with other models. This will help you assess the valuation, risk and rewards of a stock more accurately. That said, the SML makes it easier to represent the Capital Asset Pricing Model graphically and to compare the risks and expected rewards from an asset — which is also crucial for stock assessment and selection.
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