Capital Market Line Wikipedia

Today, I read capital market line content on Wikipedia. This is one of important content in its investment category. After reading this content, I understood that it is also important tool for investment analysis, Here is description of what I have learnt.

As per the Wikipedia

Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible region for risky assets. The tangency point M represents the market portfolio, so named since all rational investors (minimum variance criterion) should hold their risky assets in the same proportions as their weights in the market portfolio.
In my simple words, capital market line is the simple way to find best portfolio. Suppose, you are a good investor who thinks before investment in different shares. There are three type of stock in which you can invest. One is risk free, other is low risky and third is very very high risky stock. In risk free stocks, there is no high expected return due to zero risk but you want to become rich through your investment. So, you move to low risky stocks and in end you will move high risky stocks. But at the point of high risk portfolio, you risk of loss of investment will be high with high expected return. Do you want to loss your all money just for greed of high return? Surely, your answer is no!

So, what can you do?

You can invest in mix portfolio. What is mix portfolio? Mix portfolio is the list of your assets in which both high risky and low risky stocks are included. Now, again one question may disturb you. What mix portfolio is best for you. 70% of your total investment in high risky stocks and 30% of your total investment in low risky stocks or 70% of your total investment in low risky stocks and 70% of your total investment in high risky stocks or any other type of mix portfolio.

It means you want to equilibrium mixture of stocks. It means you want to buy risky and non risky stocks but at optimum level. Your problem can solve by understanding Capital market Line.

We should buy those stock whose Sharpe ratio is above the return on CML

formula of Sharpe ratio

S = \frac{R-R_f}{\sigma} = \frac{E[R-R_f]}{\sqrt{\mathrm{var}[R-R_f]}},

R is return for taking risky portfolio and Rf is risk free return. Sharpe ratio is just excess of return for taking more risk.

formula of return on CML =

 \mathrm{CML} : E(r) = r_f + \sigma  \frac{E(r_M) - r_f}{\sigma_M}.






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Accounting Education: Capital Market Line Wikipedia
Capital Market Line Wikipedia
Accounting Education
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