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Swedroe: Beware Of The Low Price Illusion | ETF.com

Swedroe: Beware Of The Low Price Illusion

October 26, 2016

The absolute level of a firm’s stock price is arbitrary, as it can be easily manipulated by altering the number of shares outstanding (for example, by splitting the stock). Despite this obvious fact, research into investor behavior has found a strong preference for low-priced stocks on the part of individual investors.

For instance, research has shown that individuals tend to hold lower-priced stocks than institutions. And there is additional evidence demonstrating that the number of small shareholders in a firm’s stock increases following a split to a lower price level.

It appears by their actions that companies are aware of the important role that nominal prices play in influencing investor perceptions, because companies frequently engage in actively managing share price levels in an apparent effort to cater to investor demand. For example, since the Great Depression and until at least very recently, companies have proactively managed share prices to stay in a relatively constant nominal range.

Various explanations for this behavior, which can lead to the overvaluation of low-priced stocks, have been offered. Among them are:

  • The lottery-ticket effect: As with lotteries, investors are searching for “cheap bets” that have large upside potential. They prefer positive skewness even if it means lower mean expected returns.
  • Investors may perceive lower-priced stocks as being closer to zero and farther from infinity, thus having more upside potential. They see low-priced stocks as having more room to grow and less room to lose.

The Illusion Of Low Prices

In their study, “Nominal Price Illusion,” which was published in the March 2016 issue of the Journal of Financial Economics, Justin Birru and Baolian Wang contribute to the literature on investor behavior and the “illusion” nominal prices can cause. The study used option pricing data for the period January 1996 to December 2012. The authors offer evidence that investors exhibit psychological biases in the manner in which they relate nominal prices to expectations of future return patterns.

Specifically, Birru and Wang found that investors suffer from the illusion that low-priced stocks have more upside potential. For example, following a stock split to a lower price, despite the split not changing the firm’s fundamentals in any way, they found investors’ expectation of skewness drastically increase.

 

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