Final answer:
A stock that plots below the Security Market Line is considered overpriced, as it offers a lower return for its level of risk than the market average, which contradicts typical investment preferences for a higher return on higher risk.
Step-by-step explanation:
If a return plots below the Security Market Line (SML), it indicates that the stock is overpriced. To provide some context, the Security Market Line represents the capital asset pricing model (CAPM) which illustrates the expected return of an asset for a given level of risk, as measured by the beta coefficient. The SML shows the tradeoff between risk and return for the entire market.
Positions on the SML show the comparative level of expected return for a given level of risk compared to the market average. Stocks plotting above the SML are seen as undervalued because they offer higher return for their risk level. Conversely, stocks below the SML are viewed as overpriced because they offer lower return for their risk level. This scenario suggests that the stock is not rewarding enough for the risk an investor is being asked to assume.
Investment decisions should always consider the return in relation to risk. High-risk investments, represented by a high beta, must offer higher returns to attract investors; otherwise, they will be deemed unattractive. A stock providing lower returns than expected for its risk level does not align with typical investment practices, where a higher risk is taken for the potential of higher returns.