Swedroe: Beware Of The Low Price Illusion

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.

By way of background, skewness is a measure of the asymmetry in the distribution. When a distribution is skewed to the right (meaning it’s positively skewed, like a lottery ticket’s distribution), the tail on the distribution curve's right-hand side is longer than the tail on the left-hand side, and the mean is greater than the mode.

Yet future skewness doesn’t increase; it actually decreases. On the day of a stock split to a lower price, the authors observed “a greater than 40% increase in skewness expectations.” The result is that investors overpay for the call options. They also found similar evidence of investor-expectation errors following reverse splits. On the day of a stock price increase due to a reverse split taking effect, expectations of future skewness drastically decrease. Yet future realized skewness does not decrease; it actually increases.

In addition, Birru and Wang found evidence from options trading that investors exhibit increased optimism toward low-priced stocks relative to high-priced stocks, and take lotterylike bets in low-priced stocks to a greater extent than in high-priced stocks.

For example, they found that the ratio of call-to-put open interest and volume is substantially higher for low-priced stocks than it is for high-priced stocks. They concluded the evidence shows that “investors also have a preference for utilizing the leverage benefits options provide to take lottery-like bets on these lottery-like stocks.”

The authors add: “Overall, the evidence is consistent with investors suffering from a nominal price illusion in which they overestimate the ‘cheapness’ or ‘room to grow’ of low-priced stocks relative to high-priced stocks. Our evidence also suggests that this nominal price bias has asset-pricing implications.” For example, they found that call options on low-priced stocks are more overpriced than they are on high-priced stocks.

Summary

Birru and Wang present evidence that both confirms and helps explain a nominal price illusion that leads to the asset pricing anomaly described by the overvaluation of low-priced stocks and options on low-priced stocks. It seems that investors surely do have a preference for lotterylike bets. And the authors found that investors also overweight nominal prices in assessing return distribution expectations.

They concluded: “The evidence presented is consistent with investors suffering from the illusion that low-priced stocks ‘have more upside potential.” The result is that “options of low-priced stocks are more overvalued than options of high-priced stocks.” Now, though, you no longer have the excuse of falling for the nominal price illusion.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.