The Psychology of Stock Splits and Free Trades
With Apple and Tesla recently splitting their stock, it has renewed a question about the wisdom of investing in companies that split their stock.
After a high-flyer splits their stock there is a misperception this event signifies now is a great time to invest.
We would urge caution as it is quite possible you are being manipulated.
Assume a company is growing rapidly. As they sell more, their stock grows. Once their stock grows to a certain level, management decides to split their stock.
As such, instead of having one share at $200 per share, you may now have five shares at $40 dollars per share.
This is nothing but an accounting trick. The company is not selling more or earning more. It is exactly the same company with the same value.
If it creates no value, why do companies do this?
For quite some time it was believed that individual investors preferred stocks to trade in a certain price range between $20 and $100 per share. Once they grow above $100 per share they became too expensive and trading slows.
Much of this hearkens back to an age in which trading commissions were quite a bit more and lower stock prices generated higher trading volumes and commissions.
However, with competition and better technology, the issues associated with stock splits and commission costs are about to incur a monumental change.
Most of the big discount brokerage houses now offer “commission-free” trading.
This is great, except that most people understand brokerages are not running charitable organizations. Quite the opposite—they are making more now than ever before. Obviously, if they cut commissions, the revenue must be produced elsewhere.
How can this be? And what do stock splits have to do with this?
Traditional commissions per trade may have historically been the primary brokerage money maker. However, brokers also make money from things like margin borrowing rates, mutual fund management fees and ETF management fees.
Additionally, they make handsome market-maker fees, specialist fees, mark-ups, and bid-ask spreads. These fees have always been around, however, they directly benefit from increased trading volumes. Lower stock prices induce investors to trade more often.
The most insidious trading cost comes from a very controversial act in which “trade order flow” is sold without your knowledge.
Assume you get on your Schwab or Robinhood brokerage account to buy 100 shares of Coca-Cola. The stock is trading at $48 per share.
As you place your order the broker communicates to a business partner called a high frequency trader (HFT) that an order for 100 Coke is on its way. The HFT immediately buys 100 Coke at $48 and simultaneously turns around and sells it to the broker for your account. However, even though the stock was trading at $48 per share, it is sold to you at $48.25.
The resulting trade costs you $25 more than it should have. Furthermore, the HFT’s are repeating this type of transaction millions of times a day. And then they kick-back a portion of the high frequency revenues to the brokers.
Adding insult to injury, firms like Robinhood are sending messages throughout the day to their users designed to increase trading activity.
All of this is thinly disclosed and very hard to detect. It is clearly a big profit maker for the brokers and a significant conflict of interest.
In the process, the financial industry is using the psychology of money against you. Brokers know that marketing their services as “commission-free” encourages people to trade more. The higher the trading volumes the greater the accumulation of non-disclosed trading fees.
Some companies don’t split their stock. Google trades for $1,500 per share while Amazon trades above $2,400 per share.
However, the brokers have a plan for this too; it won’t be “free.”
Soon, brokerage companies will begin trading fractional ownership of common stocks. Even if Amazon trades for $2,400 per share you will be able to buy 5% or 10% of a share or a flat dollar amount. Schwab’s program markets this as buying companies “by the slice.” Although this will offer a lower purchase sum, there will be a slew of additional expenses associated with these trades.
Understanding this, what can you do to protect yourself?
First, understand that stock splits are nothing but psychology.
Secondly, no one in the financial services industry works for free. When someone says something is “free” put both hands on your wallet.
Lastly, make sure you take control of how and when you trade. When your broker starts flashing messages at you, shut off your phone or computer and walk away. Fast or impulsive decisions are generally bad decisions.
Know what price you are willing to pay. Limiting trading reduces costs and increases tax efficiency. Wall Street will always have a faster trading system and will use it against you. The best way to win that game is to not play. Buy good businesses and hold them for extremely long time frames.