$100 is the same as ten $10 bills. And one share of Tencent at HK$567 is the same as five shares at HK$113.50 each. But our brains get in the way and make us feel like they’re not the same. And that can be a big problem when it comes to investing.
One of the biggest barriers to being a successful investor is our own brain. Normal, instinctive feelings can stop us from making good investment decisions. One of these is the “denomination effect.”
In January 2014, the shares of Tencent Holdings were trading at HK$567. The relatively high cost of a single share meant that a lot of individual investors would instead invest in shares with a lower absolute price. They felt Tencent shares cost too much.
(The valuation of a stock – that is, whether it’s expensive or cheap – has nothing to do with the absolute price of a stock. The value of a stock is calculated by looking at a company’s earnings, prospects, cash flow, and other factors, and comparing it to the price of the stock. So a stock that you can buy for $1 might be expensive… while a $100 stock might be cheap. A pair of Nike LeBron IX basketball sneakers, or Jimmy Choo shoes, might cost a lot – but if they don’t fit you (or if they’re not what you want), their value to you would be a lot less. Price and value aren’t necessarily related – for shoes and shares.)
Similarly, in June 2012, a share of Apple cost US$570. For a lot of investors, buying just twenty shares would represent a large portion of their portfolio. So even though they could buy shares, a lot of investors didn’t touch Apple stock.
This changed when Tencent and Apple split their shares. Tencent’s stock split 5-for-1, meaning stockholders would get 5 shares for each share they held and the new shares would trade at HK$113.50 (one-fifth of the previous price). Apple’s shares split 7-for-1, so after the split the shares traded at US$81.
As Apple’s CEO Tim Cook said, the split made the shares “more accessible to a larger number of investors.” And indeed, trading volumes spiked more than what was mathematically predictable. A lower share price made the shares more accessible to more investors – at least psychologically.
Of course, the underlying value of each company was unchanged. The lower share price only meant that investors could now buy in at a lower price. If they bought seven or more shares of Apple at US$81 (total US$567), or five shares or more of Tencent at HK$113.50 (total HK$567), it would have made no difference if they bought shares before or after the stock splits.
This is how the denomination effect works. Low prices can cause people to spend more – even if they end up spending the same as buying something with a higher price tag.
Studies first proved this using the cash in our pockets. It was shown that we are more reluctant to spend one $100 bill than we are to spend ten $10 bills. The value spent in both cases is identical. But the bigger bill just feels like more money.
One way investors can address the denomination effect is to think about buying the whole business, rather than just a few of its shares.
If money was no object and you could spend as much as you wanted to buy company shares, or the entire company, the share price wouldn’t matter. You would look at the company’s cash flows, future growth prospects, the quality of their product and so forth to come up with an idea of what the whole business is worth.
Then you would consider how much of your portfolio you are willing to invest in the company. So, if you’re willing to invest $100,000 in a company worth $100 million, you want to buy 0.1% of the company. The number of shares or what their trading at makes no difference. You are buying a portion of a company you believe in and want to be a part of.
So don’t look at the price of a stock. Look at the value. This will help you overcome the denomination effect.