The security market line depicts the expected return a stock gives as a function of its systematic risk. The formula for plotting the SML is required return = market return + beta (market return – risk-free rate of return).
The SML is often used by investors to evaluate whether a securities offers a favorable expected return for its level of systematic risks. This can help investors avoid taking too much risk for a small gain or taking too little risk for a large reward.
Generally, securities that are plotted above the upward-sloping SML are considered undervalued in price as they give returns higher than their risks would indicate. Conversely, securities that are plotted below the SML are considered overvalued in price as they give lower returns than the market for a given amount of risk.
Another important thing to keep in mind is that the SML does not account for idiosyncratic risks, which are non-systematic and cannot be reduced by diversification. This is why it is important for investors to understand and evaluate a security’s intrinsic risk before making any decisions.
Several exogenous factors can impact the slope of the SML, such as inflation, a recession or investors becoming more or less risk-averse. The SML may also shift in value from time to time, depending on the market’s view of what the appropriate expected return should be for a given amount of risk.