Year: 2022

Imagine selling slices of a large pizza. You can cut it into four even slices and charge $2 a slice. Or, you can cut it into eight even slices and charge $1 per slice. Either way, the total value of the pizza will still be $8.

That’s what happens when a stock splits. Let’s say a stock’s market price is $100. With a 2-for-1 split, each current owner receives one additional share for each share he owns. Now, each share is worth $50. If you had one share to start, you now have two, but the total value of the investment remains $100.

A stock split differs from when a company decides to issue new shares, wherein new shares flooding the market can dilute the value of existing shares. With a stock split, the value of existing shares do not decrease. The total market value of a shareholder’s holdings will remain the same.

There are different forms of stock splits, such as the 2-for-1, 3-for-1, or 3-for-2 stock split. They all work the same way: You get two shares for everyone you hold, or three shares for everyone you hold, or three shares for every two shares you own.

Another, the less common form is called the reverse stock split. This is when a company decides to reduce the number of outstanding shares, which in turn will increase the stock price of shares held by stockholders. This strategy is generally used to boost the price of a stock that has lost value over time.

It is important to recognize that the stock split is a simple strategy designed to affect the stock price. It in no way changes the company’s market capitalization (i.e., total value of all outstanding shares) or other fundamental metrics. In order to issue a stock split, it must be approved by both company management and the board of directors. Furthermore, the company must publicly announce its intention to conduct a stock split within days or weeks of implementation.

The timing of the announcement is important because some investors try to take advantage of a stock split, believing that the value of the stock will increase as a result. This has more to do with market sentiment than any change in company fundamentals.

For example, in the past when a stock split its value often returned to its pre-split price within a year. This is not necessarily because the company has improved fundamentals, but rather because the investor market simply believes that stock is worth that price — it’s a form of confirmation bias. However, in recent years it is not as common for split stocks to climb back to their original price as it was in the past.

Why Conduct a Stock Split?

Again, the reason for a stock split is largely driven by market sentiment. For example, some investors may not have a lot of discretionary income to invest, so they look for a lower-priced stock. While they might not consider a stock valued at $100 per share, they may be interested in the company at $50 a share. In fact, following a recent stock split, investors may see it as getting a bargain price for that stock. As such, they might buy two shares. Now they’ve spent $100 on two shares whereas they were reluctant to buy one share for $100. The value is the same, but psychologically, that stock now seems like a great buy. This is referred to as unit bias. Psychologically, most people perceive lower per share prices to mean that a stock is “cheaper” and therefore may have more room to make gains.

In addition, now they can further diversify their portfolio with different stocks, whereas before those high-priced shares may have dominated their portfolios, exposing them to greater market risk.

A stock split also gives current shareholders the opportunity to increase their holdings at half price. While the value hasn’t changed when they make the buy if the stock increases in the future their portfolio will increase in value because they have more shares of that stock. For example, let’s say you have 10 shares of a stock priced at $10, for a total value of $100. The stock splits 2-for-1, so now you have 20 shares priced at $5, still valued at $100. In a few years, the stock price grows to $20 per share. Had the stock not split, your total value would grow to $200. But because you now own 20 shares, the total value of those shares would grow to $400.

Clearly, the true value of a stock split comes from holding those shares until the price increases substantially.

Mutual Fund Split

Some mutual funds also engage in the split strategy, but instead of splitting an individual stock, the fund company issues additional shares of the fund at a reduced price. In all other ways, a mutual fund share split works like an individual stock split.

If you’d like to learn the history of a company’s stock splits, consider the following resources:

• Click on the investor relations tab on the company website, which often provides a history of the company, including dates of past stock split activity.
• Search by the ticker symbol at stocksplithistory.com or Morningstar.com.
• Another option for both stocks and mutual funds is to search by the stock symbol at Yahoofinance.com. On the stock’s performance chart, look for the Events tab and check the Stock Splits option. You may need to reduce the historical time frame to see splits marked clearly.
• You also may be able to search for stock split history on the website of your online broker. Many outfits offer these types of research tools.

Often the first house a person buys is an affordable condominium, townhouse or older single-family dwelling, also referred to as a “starter home.” It might be small and lack features they dream about, from new appliances in the kitchen, to dual sinks in the bath, to a large yard or a garage.

However, the key to a starter home is not to acquire your dream house, it is to build equity that you can eventually deploy to buy your dream home. It’s important not to wait until you have enough money for the ideal property. Start as early as you can and buy something affordable to get your foot in the door of homeownership.

Interest Rates and Maintenance Expenses

Buying a home when mortgage interest rates are low offers a key advantage for building wealth because it reduces your loan payment, thereby freeing up more discretionary income to put toward other investments, home upgrades or pay down the mortgage balance.

When deciding your price range for purchasing a home, it’s also important to budget common maintenance costs, such as utilities, repairs and upgrades, as well as homeowner’s insurance and property taxes. These costs can be substantial, yet many new homebuyers do not account for them in their budget. They only take into consideration whether or not they can afford the monthly mortgage. It is always a good idea to have a lower payment that you can well afford in order to avoid relying on savings or credit to pay for maintenance expenses as they arise. And remember, maintenance of your property is critical because it can help improve your sale price when you move, which is key to building wealth.

Building Home Equity

The next step to building wealth through homeownership is to sell for a substantial profit. Home equity, which is the market price for which you can sell the home minus your remaining mortgage balance, is achieved in two ways. One way to build equity relies on the real estate market. Over time, houses generally increase in price, so most people are able to sell their home for more than they paid for it. How quickly home prices rise will depend on the overall economy and your home’s particular appeal. That’s why it’s important to make an attractive location one of your top requirements. For example, even if you don’t have children or want children, buying a home in a sought-after school district will likely increase the value of your home faster. Other location features include easy access to shopping districts, major highways and even an airport.

The second way to build equity is through the monthly payments you make on the mortgage, which reduce the balance owed. If you can afford it, adding more to your monthly payment and directing the excess toward your principal balance helps build home equity faster. Another payment option that can help build equity faster is to apply for a shorter-term loan than the standard 30-year mortgage. For example, a 15-year term mortgage features a lower interest rate and the borrower pays off the loan in half the time. Note that monthly payments will be higher, but a homeowner can save thousands of dollars in interest with a shorter-term loan.

Transaction Costs

The garden variety advice is to remain in your home for at least five years. That’s because selling your home and buying a new one involves substantial transaction expenses, from closing costs to initiating a new loan, as well as paying commission fees to both the seller’s and buyer’s real estate agents (usually 3 percent each). Therefore, you need to have lived in the property long enough to build equity through payments and market appreciation to offset these expenses and still make a profit.

Sales Tax

Be aware that it is advantageous to live in your primary residence for at least two years before you sell. Otherwise, your sales profit could be subject to capital gains taxes on the first $250,000 for single tax filers, and as much as $500,000 for married filing jointly. The tax rate is the same as your ordinary income tax rate if you owned property for less than one year; after that, the capital gains rate is based on your tax bracket (15 percent or 20 percent).

Trade Up, Then Down

Over many decades, you can build wealth by buying a home and then periodically “trading up” once you attain substantial equity. The tactic of trading up means you invest your profits in a more expensive home and then begin building equity again. One way to save for retirement is to keep trading up until you retire, then downsize to a less expensive home with lower maintenance expenses. At that point, you can redeploy the profit derived from the home equity you have accumulated into a stream of retirement income.

Today’s Market

In recent years, high prices and low inventory in the residential real estate market have made it harder for young adults to buy a starter home. For those currently shut out, keep saving until the market stabilizes, because the higher your down payment, the lower your monthly payments will be – and the more equity you’ll have in your home. You can still build wealth through homeownership, even if you start late.