Can Beta be Negative?
A common interview question! Let us look at it from a practical perspective.
What does negative beta denote?
Beta denotes the risk a stock adds to a diversified portfolio. If the stock is actually reducing the risk of the portfolio, then beta could be negative. In addition, a -ve value of beta means that the investment moves opposite to the diversified portfolio. Gold for example is considered by many to be a negative beta asset class.
However, this is an extremely unlikely scenario for a common stock.
Recall the CAPM equation.
Cost of Equity = Risk Free Rate + (Beta X Equity Risk Premium)
If Beta is negative, Cost of Equity < Risk Free Rate.
For any company, there would be a finite amount of risk, including default risk, liquidity risk, execution risk. So for a common stock, it is unlikely to see negative beta.
However, if an investment acts as an insurance for the overall portfolio, then we can observe negative betas. For example, if I am buying puts against my portfolio, or selling future contracts on the index, this position would have negative beta.
Only if an investment acts as reducing the risk to a fully diversified portfolio, while moving opposite to the underlying portfolio, is it likely to have negative beta.
Remember, statistically we may sometimes get negative values for beta while regressing the stock returns against the index returns. Usually, this is to be ignored, since most likely, this is a result of a sample time period where the stock has just moved opposite to the index. In such cases, we need to find beta over different time periods.
Till next week. Keep Learning!