Portfolio Management - SML Portfolio in Equilibrium

Hi,

I thought this was an easy question but I got it wrong. Wondering what your thoughts are; any explanation would be helpful.

Portfolios that plot on the security market line in equilibrium:

A) must be well diversified.

B) have only systematic (beta) risk.

C) may be concentrated in only a few stocks.

It isn’t true that such a portfolio must be well-diversified; even some single-security portfolios might (accidently) plot on the SML.

It isn’t true that such a portfolio has only systematic risk; the SML doesn’t measure nonsystematic risk.

It’s certainly true that such a portfolio may be concentrated in only a few stocks; see the first sentence, above.

Isn’t the SML based on CAPM which only measures systematic risk? In equilibrium investors only get compensated for the systematic risk since they can diversify away firm-specific risk?

Also, isn’t SML only for individual securities while CML is for portfolios consisting of the risk-free asset and the market portfolio?

Yes.

Yes.

No.

The SML is useful for all well-diversified portfolios, whether they lie on the CML or not.

So if the SML is used for all well-diversified portfolios and only measures beta risk, why is B) wrong?

And is the CML considered a well-diversified portfolio?

The SML isn’t used exclusively for well-diversified portfolios; you can plot any portfolio against it. And the fact that it measures only beta doesn’t mean that a portfolio plotted against it has _ only _ systematic risk; it can have a ton of nonsystematic risk that simply won’t appear in this particular plot.

We can think of SML like a single line representation of all CALs.

Magician is right - the SML gives required rates of return for either individual securities or portfolios. What might confuse some is that one of the underlying assumptions of the SML is that investors _ already hold well-diversified portfolios _. So, idiosyncratic (unsystematic) risk is diversified away, and all that gets priced is an asset’s exposure to systematic (i.e. undiversifiable) risk.

The asset being priced (i.e. the one for which you’re assessing required rate of return) can have exposure to unsystematic risk, but the asset’s unsystematic risk doesn’t get priced - only its systematic risk exposure.