Capital Allocation line, Security Market line and Efficient Market Frontier
Capital Allocation Line (CAL)
CAL shows all combinations of risky and risk-free assets, given a certain level of risk while identifying the maximum returns. CAL will help the investors in constructing portfolios and maximising their returns based upon their risk-appetite. Based upon their risk-appetite they can add both risky and risk-free assets to their portfolios by giving different weights to these assets.
The overall risk of the portfolio would be that of the risky asset in relation to its weight in the portfolio. Risk-free assets, by definition, do not contain any risk and therefore, the risk element would be zero and the Expected return of the portfolio is computed taking into account the expected return of both risky and risk-free assets while considering the volatility of the portfolio.
It can be formulated as :
Ep = E(rs) * w + (1-w) * E(rf)
Security Market Line (SML)
SML is a visual representation of the capital asset pricing model or CAPM. It shows the relationship between the expected return of a security and its risk measured by its beta coefficient. Any security plotted above the SML is interpreted as undervalued. A security below the line is overvalued.
Fundamental analysts use the CAPM as a way to spot risk premiums, examine corporate financing decisions, spot undervalued investment opportunities and compare companies across different sectors. It can also be used to study the investors behaviour by economists.
CAPM:
E(Ri) = RF + βi × (E(RM) - RF)
Several different exogenous variables can impact the slope of the security market line for e.g the current economic slowdown can make the investors more risk-averse and this can cause shifts in the SML line which can impact the market risk premium.
Efficient Frontier
Scared of losing money in the stock market?
With high market valuations and an ever-lasting bull market, one might get scared to invest in equities (stocks) and stay on the side-lines. Over the long-term, the market has historically greatly rewarded equity investors but there is a balance to be found. One way such a balance can be created is by holding an efficiently diversified portfolio.
The modern portfolio theory developed by Harry Markowitz in 1952 states that it is insufficient to take a single investment approach or single asset class approach, but rather take a mixed-asset approach, which later earned him the Nobel Prize in Economics nearly four decades later.
There’s no such thing as the perfect investment, but crafting a strategy that offers high returns and relatively low risk is a priority for modern investors.
What is Efficient Frontier?
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.
One example of the benefits of efficient frontier can be quoted as ‘Holding a globally diversified portfolio with 40% bonds, historically reduced risk by 41.64% while increasing returns by 0.64% per year over a Canadian stock-only portfolio. Over the whole period (from 1970 to 2009) this slight edge adds up to a 28.25% higher end balance.
Limitations
NASCAR race cars are sophisticated, complex automobiles. In the hands of, say, Tony Stewart, they're capable of great feats. In the hands of a drunk driver, the same vehicle can be deadly. The financial equivalent of racing cars is an efficient frontier model. They're one of the most touted, yet most misunderstood and misused, tools in the field of financial planning since efficient portfolio theory relies on historical data and relationships to generate the perfect portfolio.
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