Question

Briefly discuss why stocks with low and negative betas offer such low rates of return when stocks are said to be risky in general.

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

A.

There is a direct relationship between the risk associated and the return gained.

As per Risk-Reward Relationship: The lower the risk associated in the stock, the lower the chances of gains (or losses) and vice-versa.

B.

Beta represents => Systematic Risk/Non-diversifiable risk/Market risk:

1. Risk related to the economy.
2. Cannot be killed by diversification.

For Example:
1. Suppose a war is declared between two countries.
2. Government decisions / New political party coming into power.
3. The risk due to the cyclic nature of Industry.
4. Interest rate, Inflation fluctuation risk.

Lower the cyclic nature of the business(pharmaceuticals and fast-moving consumer goods), lower the beta.
Lower financial risk (low debt to equity ratio), lower the beta.

C.

As beta (i.e the systematic risk) becomes low, the return is also low.

D.

Beta that is systematic risk is determined by: Rate of change of stock return to the rate of change of market return. It is the sensitivity of stock return to Market return.

Return of stock at the end of year = 15%
Return of stock at the start of year =10%
Return of the market at the end of year=25%
Return of the market at the start of year=17%

Beta = (15-10)/(25-17)
Beta of stock = 0.625

A lower Beta Represents (less than 1) that if the stock market index moves by 1% then the stock will move by less than 1% and vice versa.

Example:
Suppose Beta of a stock is 0.625, if stock market index goes down by 1% then the stock will go down by 0.625% and vice versa.

So it's better to buy lower beta stocks, during falling markets and vice versa.