Have you ever wondered how a stock’s risk profile changes as its share price falls? This question is crucial for managing investor expectations and minimizing portfolio turnover. Emotional reactions to unpredictable market movements often lead investors to stray from their long-term strategies, exposing them to additional risks beyond market volatility.
Some argue that as a stock approaches penny stock territory with a nominal share price below $5, its volatility may stabilize due to a price floor. On the other hand, others suggest that the stock could become more sensitive to market fluctuations as its survival may depend on market conditions.
A study on systematic risk and total volatility of penny stocks revealed surprising findings. As a stock’s price declines, it tends to become more reactive to market movements, with an increase in beta and total volatility.
By analyzing historical data of NASDAQ- and NYSE-listed companies over five decades, we observed that stocks dropping below $1, $2.50, or $5 per share showed a significant rise in beta after crossing these thresholds. Stocks with negative betas saw a shift from -0.62 to 1.14, while those with betas between 0 and 1.0 increased from 0.55 to 1.37.
The Findings
Notably, when a stock dipped below the $1 threshold, the average beta surged from 0.93 to 1.57, indicating a higher level of volatility compared to the overall market. The spike in beta at the $1 threshold depicted a substantial change in risk profiles, driven by increased systematic risk and total volatility.
Key Highlights:
| Beta Before Price Drop | Beta 2 Years After Price Drop | |
| Average Price Drop Cutoff: $1/share | 0.93 | 1.57 |
The study emphasized that the escalating risk in penny stocks is predominantly driven by increases in systematic risk, signifying a higher correlation with market movements. Contrary to a reversion to the mean, the results were consistent over time.
Further analysis at the $5 share threshold showcased a different scenario, implying that the risk shift observed at the $1 level is unique to entering penny stock territory. The overall findings reinforced the notion that penny stocks become riskier as their prices near the zero-price barrier, primarily due to heightened systematic risk.
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Disclaimer: The author’s views reflect personal opinions and should not be considered as investment advice. They do not necessarily represent the perspectives of CFA Institute or the author’s employer.
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