Stock Splits

If you've been investing for a while, perhaps one of your stocks have split and you've therefore had some experience with stock splits or maybe even a reverse split. But for the beginning investor who is just starting out, stock splits and reverse splits are topics that I receive lots of questions about.

Stock Splits

Stock splits are really rather easy to understand. When you see a stock rising over the years and reaching triple digits, investors often think that the stock costs too much or it has reached its peak and is going to go back down. For the company's whose stock has been doing well, this is a bad sign and they want their stock to continue flourishing.

Here is where the stock split comes in. When a company's stock price starts getting rather high, they have the option to split their stock. What this does is it gives the shareholders more shares of stock but the price drops. For example, let's say you owned 10 shares of XYZ stock at $100 and it split 2 for 1 (you would get 2 shares for every 1 share that you owned). After the split, you would have 20 shares of XYZ stock but the price would be $50. Although the stock went through a split, you still have $1000 invested in the company's stock. Stock splits are a lot like giving someone four quarters in exchange for a dollar bill.

The myth behind stock splits is that after the split, the stock will take off again. There is some truth to this but it doesn't work in all stock splits. The reason that many companies and corporations split their stock is to stimulate trading. By reducing the cost of one share of stock, more investors are appealed to the stock and they can afford more shares. Because investors are confidant again about buying stock in the company, the stock price might rise.

However, this doesn't mean that the stock will quit rising if it doesn't split. If you take a look at Warren Buffet's company, Berkshire Hathaway, you will see that their stock price is at around $80,000 per share. They have never split their stock and they still continue to grow.

Stocks can split 2 for 1, 3 for 2, 10 for 1, or any other combination. When you hear a stock is splitting 3 for 2 it simply means that investors are given 3 shares for every 2 shares that they own. The stock's price would then be reduced by 33%.

Reverse Splits

Reverse splits are a lot less common than stock splits but still rather easy to understand. As their name says, they are the exact opposite of stock splits.

In a reverse split, you exchange more shares for fewer and the price of the stock increases accordingly. But like stock splits, you still end up with the same amount of money in the stock after the split.

Companies use reverse splits to raise their stock's price. This usually deters individual investors. Individual investors are often expensive and difficult to keep track of. But because the stock price increases, institutional investors like mutual funds and firms may be given the ability to invest in the stock. Institutional investors often have price requirements for stocks such as the stock must be priced at least $5 per share. When the stock does a reverse split, it may meet that requirement and more institutional investors can invest in them.

In both cases, you still have the same amount of money after the split as you did before. They just give more investors the opportunities to invest in them. I hope this has cleared up some of the confusion associated with splits.