The Use of CML and SML in Taking Investments Decisions by an Investor on His/her Risk

Preference.
What is the CML? The capital market line (CML) represents portfolios that optimally combine risk and
return. It depicts the trade-off between total risk and return for efficient portfolios. CML derives from the
efficient frontier which reflect efficient portfolios (which are risky) that investor can invest in order to
gain optimal return for the given level of risk. CML differs from the efficient frontier in that it includes
risk-free investments. The point where CML and EF tangent with each other would result in identifying
the most efficient portfolio i.e. market portfolio. CML shows combinations of the risk free assets and
market portfolios with risky assets. Which means investor can invest either invest in Risk free investment
or the different combinations of risk free and risky portfolios based on their risk preference.

But, how CML is useful for investor to take investment decisions based on their risk preference?
Individual investors will either hold just the risk-free asset or some combination of the risk-free asset and
the market portfolio, depending on their risk-aversion. As an investor moves up the CML, the overall
portfolio risk and return increases. Risk averse investors will select portfolios close to the risk-free asset,
preferring low variance to higher returns. Less risk averse investors will prefer portfolios higher up on the
CML, with a higher expected return, but more variance. The portfolios which lies in between Risk free
investment and market portfolio on CML defined as lending portfolios, so, more risk averse investors
prefer to invest in lending portfolios. And the portfolios lies above the market portfolio on CML line
defined as borrowing portfolios, so, less risk averse investors prefer to invest in borrowing portfolios. The
investors who prefer to invest in borrowing portfolios can also invest more than 100% of their investable
funds in the risky market portfolio, increasing both the expected return and the risk beyond that offered
by the market portfolio, by borrowing funds at the risk-free rate. Hence, based on each investors risk
averseness they determined whether to invest in lending or borrowing portfolios.

Investors obtain utility over the investments that they have done. The indifference curve is a graphical
representation of the utility of an investment. An indifference curve plots various combinations of risk-
return pairs that an investor would accept a given level of utility. If the combinations of risk-return on a
curve provide the same level of utility, then the investor would be indifferent to choosing one. Higher
indifference curves give higher level utility while lower level indifference curves present the lower utility
for the investors. We get the optimal portfolio for an investor by combining their indifference curves and
CML. The utility theory gives us the indifference curves for an individual, while the CML give us a set of
feasible investments. So, the investors chose the portfolios when their indifference curves tangent with
the CML. The point where the indifference curve of an investor tangent with the CML is the optimal
portfolio for that investor where he can gain the preferred balance of risk-return pair that an investor
would accept a given level of utility.
Below graph explains how an investor use
CML for the optimal portfolio selection.
As we said earlier 1 indifference curve
gives higher satisfaction than the portfolios
lies on 2, 3, and 4. But the portfolios lie on
1 is unattainable because the investor
cannot construct the portfolio which is
outside of the CML. And investor don’t
chose the investments which lie on either 3
or 4 because the portfolios lie on 2 can give
higher satisfaction than the portfolios on 3
& 4. Therefore, the optimal portfolio of the
investor is “b”, which lies on 2 indifference
curve. At the point of P, 2 tangent with the
CML and give the optimal portfolio that
investor could invest with the given level of
utility.
Then, how we can reflect the risk preference of the investors on these indifference curves? Slope of the
indifference curves show the degree of risk averseness of the investors. So when the indifference curves
have high slope, those will tangent with the portfolios which are close to risk free investments. Hence, the
slope of the indifference curve will become steep when investors are more risk averse, then, such
investors always tend to invest on lending portfolios, while less risk averse investors who face flat
indifference curves, tend to invest in borrowing portfolios.

Now, let’s discuss how SML useful for the investment decisions of the investors.

The security market line (SML) is a line which shows different levels of systematic, or market risk (Beta),
of various marketable securities, plotted against the expected return of the entire market at any given
time. Investors can minimize the company specific risk through constructing diverse portfolios. The risk
which the investors cannot reduce through diversification is systematic risk or market risk. So, the SML
shows the return that investors expect for bearing market. SML is derived from the CML. CML shows the
trade-off between total risk and return for a combination of risk free asset and the market portfolio, while
SML shows the trade-off between systematic risk and return for an individual asset or portfolio. As well
as SML shows the graphical representation of CAPM model and applies to all securities, whether they are
efficient or not. The SML indicates all the securities present in the market and their corresponding beta
values or systemic risk contribution to the portfolio.

Systematic risk is also known as Beta. The systematic risk or the beta value at the point of market
portfolio equals to 1. So, investors can invest in any security on, below or above of the market portfolio
on SML. The beta value of the security is specific for each security. The securities where investor is
going to invest in below to the market portfolio on SML implies that investor prefer lower volatile assets
compared to market portfolio, while the securities above the market portfolio on SML, implies that
investor prefers to invest in asset which have higher volatility compared to market portfolio. However, the
securities which lie on SML and CML are fairly priced, where investor can actually obtain the return that
he expects for bearing the given level market risk. So, the investors can be indifferent between buying or
not buying when security is fairly priced. But the
investment decisions will differ when those lie below or
above the line.

The securities which lie below the line indicate that the
return that investor actually get is lower than the expected
return of that security for bearing the given level of
market risk. In this situation the securities are overvalued,
so, the investors reluctant to buy such securities. And the
investors who hold the securities start to sell those
overvalued securities. On the other hand, the securities
which above the SML indicate that those securities will
give higher return than the expected return of that
security for bearing the given level of market risk. At this
moment the security is undervalued, so, investors prefer to buy such securities since they are relatively
cheap.

Hence, The SML is frequently used in comparing two similar securities that offer approximately the same
return, in order to determine which of them involves the least amount of inherent market risk relative to
the expected return. The SML can also be used to compare securities of equal risk to see which one offers
the highest expected return against that level of risk.

Reference

https://financetrain.com/selecting-optimal-portfolio-for-an-investor/

https://www.investopedia.com/terms/c/cml.asp

https://ift.world/booklets/portfolio-management-portfolio-risk-and-return-part-i-part2/

https://www.investopedia.com/terms/s/sml.asp

https://www.abcassignmenthelp.com/modern-portfolio-theory-capm-and-related-concepts
https://www.youtube.com/watch?v=R3oAOCR2S5I&t=62s