As a inventory’s nominal share value falls, what occurs to its danger profile? The reply to this query has vital implications for managing investor expectations and lowering portfolio turnover. Afterall, buyers usually deviate from their chosen long-term methods as a result of emotional reactions to unanticipated market actions. These market-timing actions current their very own type of danger, including to the present danger of unpredictable markets.
Some would argue that as a inventory approaches the decrease finish of penny inventory territory, volatility will average as a result of there may be an inherent threshold under which the value can not drop. Others would contend that the inventory will change into extra delicate to market actions as a result of market circumstances dictate the survival of the corporate.
We investigated what occurs to systematic danger and the overall volatility of a inventory when it turns into a penny inventory, i.e., its value drops under $5 per share. The outcomes could shock you. We discovered that as a inventory declines in worth, it turns into extra delicate to market actions. In different phrases, its beta will increase and its whole volatility will increase accordingly.
We pulled inventory returns on all NASDAQ- and NYSE-listed corporations going again 50 years. We examined shares that through the 50-year interval crossed the edge of $1 a share, $2.50 a share, or $5 a share. We captured the situations when every inventory crossed these thresholds for the primary time. We then famous the beta of the shares earlier than the edge crossovers and in contrast them to the identical betas of the shares two years after the crossover date.
The Findings
The primary fascinating discovering is that when a inventory dips under the $1 threshold, on common, its beta goes from 0.93 to 1.57. A beta larger than 1.0 means a inventory’s value is extra unstable than the general market, i.e., its value swings extra wildly. The alternative is true of a beta lower than 1.0.
The leap in beta to 1.57 from 0.93 for the shares that dipped under the $1 threshold represents a big shift in danger profiles. In actual fact, it’s statistically vital at 1%. On the $1 threshold, the typical penny inventory has way more systematic danger and whole volatility. And this shift is throughout the board. Shares with unfavorable betas go from a mean of -0.62 to 1.14. Shares with betas between 0 and 1.0 go from 0.55 to 1.37. And shares with betas larger than 1.0 go from 1.95 to 1.88.
What occurs to systematic danger and the overall volatility of a inventory when it turns into a penny inventory:
| Beta Earlier than Value Drop | Beta 2 Years After Value Drop | |
| Common Value Drop Cutoff: $1/share | 0.93 | 1.57 |
| Beta under 0 | -0.62 | 1.14 |
| Beta between 0 and 1.0 | 0.55 | 1.37 |
| Beta larger than 1.0 | 1.95 | 1.88 |
| Beta Earlier than Value Drop | Beta 2 Years After Value Drop | |
| Common Value Drop Cutoff: $2.50/share | 0.90 | 1.56 |
| Beta under 0 | -0.55 | 1.01 |
| Beta between 0 and 1.0 | 0.52 | 1.27 |
| Beta larger than 1.0 | 1.90 | 1.94 |
| Beta Earlier than Value Drop | Beta 2 Years After Value Drop | |
| Common Value Drop Cutoff: $5/share | 1.00 | 1.07 |
| Beta under 0 | -0.56 | -0.51 |
| Beta between 0 and 1.0 | 0.47 | 0.50 |
| Beta larger than 1.0 | 2.02 | 2.17 |
The outcomes spotlight that this drastic improve in danger (volatility) is fully as a result of will increase in systematic danger, i.e., motion with the market index. Notably, these outcomes should not pushed by a reversion to the imply over time in betas.
On the excessive finish of our research, we examined when shares cross the $5 a share barrier. The outcomes look fairly completely different. Earlier than a inventory crossed the $5 threshold, on common, its beta is 1.0 and afterward it’s 1.07. The opposite beta tiers at $5 a share confirmed the identical outcomes. This affirms that the $1 threshold outcomes are really because of the inventory getting into penny inventory territory.
The outcomes help the concept penny shares change into way more dangerous (larger volatility) as they strategy the zero-price barrier and that this danger is because of will increase in systematic danger (elevated sensitivity to market actions).
If you happen to appreciated this publish, don’t overlook to subscribe to the Enterprising Investor.
All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.
Skilled Studying for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report skilled studying (PL) credit earned, together with content material on Enterprising Investor. Members can report credit simply utilizing their on-line PL tracker.
