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Nov 20, 2008

Stock Market Rules Do the Unexpected

11/20/08 - The New Republic by Clay Risen   --> Source

[edited] Normally, this would be a great moment for buyers, with the potential to boomerang the market upwards. But there are a few reasons why it’s a little too early to expect such an outcome. First, as the Reuters article notes, many institutional investors are barred from buying stocks below $10, which means some of the only people left with cash on hand are unable to participate.

In the spirit of "No good deed goes unpunished", I suggest "No mindless government restriction goes unused". Politicians are not usually analysts or businessmen, and they like rules that are simple, "obvious", and often stupid.

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Here is a disastrous consequence to a minor but mindless rule. Stocks that trade for less than $1 per share (penny stocks) are usually considered "cheap" and risky, and many are. The low price is arranged by the company to make 100 shares affordable to the people who want to invest with only a little money.

Laws that force "prudent" investing stop many institutions from buying penny stocks which they wouldn't buy anyway, and they go further to prohibit buying stocks priced at less than $10 per share. These laws require buying "quality" stocks, and they associate quality with price.

Actually, the price of a share of stock is arbitrary. It depends on what piece of the company is represented by a share of stock. Warren Buffet's company Berkshire Hathaway sells for more than $70,000 per share. It seems that he likes it that way so he does not have to deal with small investors.

It is common for companies to "split" their stock if the price goes too high, so that ordinary investors can buy the usual 100 shares. Say the stock is priced at $80/share. The company issues a "4 for 1 split", issuing 4 new shares to each owner of an old share, and taking back the old shares. The new shares are worth $20/share. Nothing has changed except each old share has been cut into 4 pieces.

There is also a "reverse split" where the company collects 4 shares and issues 1 new share, which then has a market price 4 times the old price. They have glued four old shares together.

The $10 rule is based on appearances, so that congressmen can say that they passed laws to require prudent investing in quality stocks. Actually, quality is not directly related to stock price. In the current financial crisis, part reality and part panic has sent the stock price of many quality companies below $10 to bargain prices. Many institutions who can analyze their true worth could start buying to support and raise those prices, except for this rule.

I fear the other thousands of mindless, general rules that are keeping our society from its best accomplishments.

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