When researching stocks for investment, analysts often lookout for what is known as the beta value to determine the volatility of a stock compared with the volatility of the market as a whole. That is, it indicates how much the price of a stock tends to fluctuate up and down compared to other stocks present in the market. The beta calculation is done by regression analysis which shows security's response with that of the market. In a comparison of the benchmark index e.g. NSE Nifty to particular stock returns, a pattern develops that shows the stock's response to the market risk. This helps the investor to decide whether he wants to go for the riskier stock that is highly correlated with the market (beta above 1), or with a less volatile one (beta below 1). A high beta means the stock price is more sensitive to news and information and will move faster than a stock with a low beta. In general, high beta means high risk, but also offers the possibility of high returns if the stock turns out to be a good investment. For example, if a stock's beta value is 1.3, it means, theoretically this stock is 30% more volatile than the market.
Here is a basic guide:
Beta of 0: Basically, cash has a beta of 0. In other words, regardless of which way the market moves, the value of cash remains unchanged (given no inflation).
Beta between 0 and 1: Companies that are less volatile than the market have a beta of less than 1 but more than 0. Many utility companies fall in this range.
Beta of 1: A beta of 1 means a stock mirrors the volatility of whatever index is used to represent the overall market. If a stock has a beta of 1, it will move in the same direction as the index, by about the same amount. An index fund that mirrors the S&P 500 will have a beta close to 1.
Beta greater than 1: This denotes a volatility that is greater than the broad-based index. Many new technology companies have a beta higher than 1.
Negative Beta: A beta less than 0, which would indicate an inverse relation with the market, is possible but highly unlikely. Some investors argue that gold and gold stocks should have negative betas because they tend to do better when the stock market declines.
The reason negative betas pose a dilemma to many is that they seem to go against intuition. After all, if a beta of 1 is average risk and a beta of 0 is riskless, how can an investment have negative risk?
Consider what beta represents: the risk that an investment adds to a well-diversified portfolio. Through that meaning, a negative beta investment is one that, when applied to a portfolio, reduces the overall risk of the portfolio. A more interesting way to approach this is to see negative beta instruments as insurance against economic risks that affect your overall portfolio.
A standard example that is offered for a negative beta investment is gold, which acts as a hedge against higher inflation. However, it is very important to note that a negative beta coefficient does not necessarily mean the absence of risk. Instead, negative beta means the asset protects you from major market downturns. If the market continues to rise, a negative-beta investment will lose money due to opportunity cost (the loss of the opportunity to earn higher returns) and inflation risk (the risk that a low rate of return will not keep up with inflation). The act of investing in negative or low-beta stocks raises these risks over time because the stock market has traditionally delivered a positive return in the long run.
While negative beta stocks are theoretically possible, they are likely to be rare in real life. Any time a negative beta has been discovered in practice, it has either been due to a data error or because the sample size was too small for the negative beta to be statistically meaningful.
But now there is an interesting real-life case of a negative beta stock: Zoom Video Communications, Inc. During the Covid-19 pandemic, there was a compelling argument that Zoom should have a negative beta. The argument goes that if the pandemic rages, the economy fails as Zoom soars, and if the pandemic subsides, the economy recovers, people resume face-to-face meetings, and the Zoom trend fades.
Interestingly, the data supports this theory. The US declared Covid-19 to be a national emergency on March 13, 2020, a couple of days after the World Health Organization (WHO) declared it to be a global pandemic. From March 13, 2020, till August 21, 2020, Zoom had a beta of -0.39. All betas are relative to the S&P 500 index. This was a significant change from the days before the pandemic. Zoom had a beta of 1.81 from its IPO in April 2019 to the end of the year. The high beta stock became a negative beta stock in a matter of weeks. More intriguingly, with high vaccine coverage and events, Zoom appears to be reverting to a high positive beta stock. Negative betas may be a rare occurrence, but Zoom's example demonstrates the presence of one of the many anomalies in the financial ecosystem.
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