Why are US stock pricing conventions so sticky?

By Felix Salmon
June 22, 2012

Last week I explained why Wall Street prefers lower-priced stocks: they mean that bid-offer spreads are wider, in percentage terms, and when that happens, brokers make more money.

So it comes as little surprise to see that Wall Street is now agitating for some stocks to trade in increments of 5 cents or 10 cents, rather than the current 1 cent:

Brokerage firms often can’t afford to spend money developing reports on thinly traded companies because firms are less likely to make back that money through commissions linked to trades in such securities, said Healy. With less research available on small-cap companies, mutual funds and other institutions may not be inclined to invest in such stocks, he said.

Of course, there were lots of silly reasons put forward too: one executive even said that he was pushing the change for investors‘ sake, on the grounds that they “like round numbers”. But the real reason is the obvious one: the higher the bid-offer spread, the more money brokerages make. I, like Alex Tabarrok, am naturally suspicious when industry insiders say that higher tick sizes are in the public interest.

But there’s something else going on here, surrounding the semiotics of nominal share prices. The fact is that it’s pretty easy to choose a wide or a narrow bid-offer spread without changing tick sizes at all: if you want a wide spread have a low nominal share price, and if you want a narrow spread, have a high nominal share price. Anything over $50 or so will give you the narrowest possible spread, since bid-offer spreads almost never go lower than 2bp. On the other hand, if you want a spread of 30bp to allow Wall Street to make a killing, then just do a big share split which results in a share price of $3 or so.

Why don’t companies do this? Because nominal share prices matter, at least to retail investors. After I wrote my last post, a Wall Street veteran emailed me:

Trust me on this: Individual investors HATE HATE high-priced stocks. I know the logic makes no sense but you simply cannot sell a $70 stock to an individual unless it’s a very well-known blue chip. They hate it.

You would be surprised to hear how many people say that they’re looking for something “in the $23 range.”

This is weird, and irrational, but true. What’s more, individual investors are highly suspicious of very low-priced stocks, too. If Apple suddenly announced a 150-for-1 stock split, so that its shares started trading at $3.86 apiece, that would be bearish for the stock, the conventional wisdom that investors like stock splits notwithstanding. A company whose shares trade below $4 just feels as though it’s small, or struggling: certainly not a world-beating behemoth. (Incidentally, if Apple did do that 150-for-1 stock split, it would have 140 billion shares outstanding, and would trade on average 3.1 billion shares per day.)

The subtext of nominal share prices, beyond the obvious realm of penny stocks, is something I’ve never been good at understanding; if you know any good guides to it, I’d love it if you could point me in their direction. And even penny stocks don’t make a lot of sense to me: if you don’t want the stigma of being a penny stock, why don’t you just do a reverse stock split?

In any case, for reasons I don’t pretend to understand, it’s obviously a lot easier to try to change tick sizes than it is to change nominal pricing conventions. Some things are incredibly sticky, even if they don’t make any sense. I guess they’re a bit like that weird American love of pounds and miles and gallons.

7 comments

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Can’t remember whether it was at A Level or when doing the Blue Button exams….all too long ago. Mebbe even finance part of the LSE degree. But the point was made that the US markets seem to prefer $10 to $50 as a price and the London markets £1 to £10.

But the point was made that the desire to be in these trading bands was what might justify a stock split or consolidation.

No one ever did explain why the bands should be different in each country. But it was used as a reason why ADR’s are normally a multiple of UK shares.

Posted by TimWorstall | Report as abusive

Maybe it has something to do with how much stock people think they need to buy, or can afford to? It may be that Apple’s stock price isn’t unreasonable in p/e terms, but no one wants to buy only four shares. But you could buy 100 shares of a $20 stock for the same investment. I say this because the last time I had the urge to buy stock, it was Apple when it was 16, and I had no money. I would have taken 100 shares at that price if I could have spared it, but I was totally broke.

Posted by Moopheus | Report as abusive

Are there any practical reasons these days not to buy shares in odd lots? Four shares of Apple might not sound very exciting, but I don’t see how a 25:1 split would change anything.

Posted by TFF | Report as abusive

DOJ Antitrust settled a major price-fixing case against NASDAQ in the 1990s involving bid-ask spreads. Academic studies showed that NASDAQ listed stocks were not traded at odd 1/8ths, ie 10 and 1/8ths, 10 and 3/8th. DOJ alleged a conspiracy to widen the profit margin by prohibiting trades at odd eighths. (in effect, the minimum spread was 1/4.) NASDAQ’s defense was that wider spreads were needed to provide liquidity. However, NASDAQ settled with a stipulation not to set spreads anymore, and also paid some hefty damages. I imagine this case, even though not adjudicated, would prohibit the industry from actions to keep spreads above a certain level.

Posted by maynardGkeynes | Report as abusive

Individual investors do not want to be seen as “odd-lotters”, so that’s a part of it. Another part is, naively, the investor often thinks in terms of a stock price that can double; it is easier to imagine a $20 share going to $40 than it is imagining a $575 per share price increasing to $1150. (I must admit I fall for that particular heuristic more that I’d like.)

Posted by mutant_dog | Report as abusive

In addition to mutant_dog’s reasons (odd lots, possibility of doubling), I wonder if some is that individual investors often have a fixed amount to invest at a given time, and want to minimize left-over funds. E.g. I often have $2K to invest. At $575/share, there’s $275 “left over,” versus only $22 at $23/share.

That’s a particular heuristic I’m very guilty of — so, I end up just buying index mutual funds where I can have fractional shares.

Posted by Machev | Report as abusive

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