Ask Colin

Why do companies split their shares - I've been told it's for liquidity purposes?

There seem to be three, partly overlapping reasons:

1. Most countries seem to have a range in which share prices need to fall if they are seen to be reasonably priced. In Australia it is about $10. However, it is changing as more of our companies also trade overseas, because in the US it is about $100. So, shares are split here and in the US to bring them back into the range where they are seen to be not too expensive. This is, of course simply an illusion, but psychology is more important than reason in markets.

2. There is some strong evidence that lower priced shares go up faster in percentage terms than higher priced shares. People focus on money instead of percentage. So, one way to give your shares some life is to split them. There is good research backing this up and some people actually trade the concept by buying shares about to split.

What happens in a bull market is that prices rise and shares are split. The effect above lasts while the bull market is alive. However, once the bear market comes, they go back to original vale, which after the split is a fraction of the post split high.

3. Liquidity is a factor. There needs to be enough shares for people to trade at a normal sort of price. Berkshire Hathaway is Warren Buffett's attempt to make reason prevail over psychology. He is right intellectually, but wrong if you consider normal people with their lack of his numeracy.

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