by Archie M. Richards, Jr., CFP^®
July 4, 2005

George writes, "The stock of the company I work for will be splitting soon. Should I buy the stock after the split?"

Three issues are involved, George. First, stock splits don't amount to a hill of beans. They occur because a company has performed well and its stock price has risen. The split reflects what has happened in the past. It doesn't reflect what will happen in the future. Maybe the company will continue to perform well; maybe it won't. The stock split predicts nothing.

The sole purpose of a split is to bring the price of the stock down to where investors can feel comfortable buying it. If the price rises above $90 a share, for example, many investors think they can't afford it.

Say a company has 100 million shares of stock outstanding and declares a 3-for-1 stock split. On the effective date, it will no longer have 100 million shares of stock; it'll have 300 million shares. For every share investors own, they will own three.

On the split's effective date, the price of the stock falls from $90 to $30. The company's market value doesn't change. Its shareholders hold three times as many shares at one-third the price. Except to bring the price down to a more comfortable level, the stock split changes nothing.

Well, actually the split does have a small effect, but not the one you're looking for:

When a Board of Directors announces a split, some smart investors say to themselves, "I know that splits add no value to a company except to bring the stock price down. But other, less-knowledgeable investors think that stock splits do add value. I will therefore buy the stock now, before the split occurs, and sell it to the less-knowledgeable investors afterwards."

Because of this reasoning, the prices of stocks tend to rise a little before the split occurs and fall back afterwards.

Say the price before the split announcement is $90 a share. Because of sophisticated traders, as above, the price rises to $90.3.

On the day the split becomes effective, the price falls - plunk! - to $30.1. Then, despite buying by ill-informed investors, the price, all else being equal, drops back to $30.

I wouldn't fool around with stock splits, especially not after they occur.

The second issue: Split or no split, if you have to pay for your employer's stock entirely out of your own pocket, I wouldn't do it.

Now, don't look a gift horse in the mouth. If you're receiving stock options in your company's stock, fine, accept them. If your employer matches your investment in buying the stock, why leave money on the table? But when it comes to buying the company stock with nothing but your own money, let it go; put your money elsewhere.

Here's why: Your current income depends on the company surviving. Don't make your retirement income depend on its survival as well. The employees of Enron tried that. They owned company stock up to their eyeballs and were on their way to joining the rich and famous. Whoops, Enron crashed, and the employees lost both their jobs and their retirement income.

The third issue: Why bother with purchasing individual stocks anyway? Individual stocks rise and fall like roller coasters. They're more volatile than entire markets. In the long run, it's hard to beat markets with individual stocks. Those short-term movements require crystal balls. I used to have one of those things, but it broke.

Acquire entire markets instead, using broad-based index funds or exchange-traded funds. The politics and technologies of the world are improving. People are producing wealth ever faster. Just go along for the ride. Don't fool with individual stocks. Through index funds or ETFs, buy thousands of stocks from throughout the world and just hang on. The chances are, your risk will go down, and your returns will go up.

In sum, forget about stock splits, especially after the split. Don't buy stock in the company you work for with only your own money. Finally, concentrate on index funds or ETFs, not individual stocks.