The Psychology Behind Stock Splits: Why They Matter More Than You Think

Stock splits are making a comeback in the market as shares of popular companies continue to soar. Walmart kicked off the trend with a 3-for-1 split in February, followed by eight other companies announcing similar plans by July. Nvidia recently completed a highly anticipated 10-for-1 split, only to be outdone by Chipotle’s massive 50-to-1 split last week.

To the rational investor, a stock split may seem insignificant. Why would someone prefer 10 dimes over a dollar bill? However, the main reason stock splits matter to shareholders is our tendency to struggle with mental math.

A stock split simply adjusts the number of total shares and proportionately adjusts the share price to maintain the total value. Most commonly, a forward split occurs, where the number of shares increases and the price per share decreases. Forward splits typically happen when a company’s share price has risen sharply, signaling optimism from management about the company’s future.

On the other hand, a reverse split is often used by struggling companies whose share price has fallen to concerning levels. WeWork, for example, attempted a 1-for-40 reverse split last August in a failed effort to retain its listing on the New York Stock Exchange.

While stock splits were more common in the past due to trading cost limitations for individual investors, the practice slowed significantly in the early 2000s and nearly disappeared after the 2008 financial crisis. However, the recent resurgence of stock splits raises questions about their relevance in today’s market environment.

Recent research in behavioral economics suggests that human tendencies towards non-proportional thinking and ratio bias play a significant role in how stock splits impact prices. This cognitive bias leads investors to perceive “cheaper” stocks as more of a bargain, influencing post-split stock price volatility.

Despite being immaterial in the long run, stock splits continue to affect short-term prices due to investors’ mental heuristics. As more companies announce plans to split their shares, it’s clear that this age-old practice still holds sway in the modern market landscape.