CML vs SML: Key Differences Every Investor Should Know
CML (Capital Market Line) plots every efficient portfolio combining risk-free assets and the market portfolio on a straight risk-return graph. SML (Security Market Line) graphs expected return versus systematic risk (beta) for any individual security or portfolio, not just efficient ones.
Investors confuse them because both lines appear in the same CAPM chart and both link return to risk. In practice, CML guides asset-allocation mixes, while SML decides if a single stock is mispriced.
Key Differences
CML measures total risk (standard deviation) on the y-x axes; only efficient portfolios lie on it. SML measures systematic risk (beta); all securities, efficient or not, can be plotted. CML uses the risk-free rate as its intercept; SML uses the same intercept but different slope for beta.
Which One Should You Choose?
Use CML to decide the split between a risk-free fund and a broad index ETF. Use SML to screen single stocks: if a stock plots above the line, it may be undervalued; below, overvalued.
Examples and Daily Life
Imagine you have $10k. CML tells you 60% in a Treasury bill and 40% in an S&P 500 ETF is efficient. SML then shows that Tesla’s expected return is higher than its beta-predicted return, hinting it could outperform.
Can a portfolio be on both CML and SML?
Yes. A fully diversified market portfolio sits on both because its beta equals 1 and it’s efficient.
Is beta the only risk in SML?
No, SML assumes only systematic risk matters because unsystematic risk can be diversified away.