When buying a stock or mutual fund, does share price matter?

QUESTION: My wife and I have a difference of opinion when it comes to purchasing stocks or mutual funds. I say you should buy a good-performing stock or fund with a lower cost per share because you can get more shares. Plus, (I think that) lower-priced shares tend to rise quicker and at larger increments than higher-priced shares. My wife says it doesn't matter whether you buy low- or high-priced shares, it all evens out in the end. Is either one of us right?

-- Mark Haynes
ANSWER:

First, let's talk stocks. When purchasing a stock, you'll have an easier time trading and pay lower commissions if you buy what's known as a "round lot," which is typically 100 shares. But a round lot of high-priced shares can be an awfully big gulp: A hundred shares of IBM (IBM), for example, would set you back about $10,400 these days, and that's before commissions. So in this sense, lower-priced stocks are a little easier and cheaper to trade.

That feeling comes into play when a company decides to split its stock, as many of them opt to do when their shares hit price levels of more than, say, $100. The aim is purely to make the stock appear less expensive, even though the actual value stays the same: One share at $100 is the same as two at $50. (In practice, share prices tend to rise after a split announcement, although there's no strictly rational reason for them to do so.) But whatever a stock's absolute price, it's much more important to consider its valuation -- that is, its price in relation to various fundamental performance measures, to its historical price, and to its peer group's price.

Now, mutual funds are a little more confusing. In fact, a fund's share price can be a highly misleading indicator. Unlike stocks, the NAV doesn't hold clues to a fund's return or its popularity among shareholders. That's because the NAV isn't dependent on demand from investors, but on the stocks and bonds held in the portfolio. A fund's NAV reflects the actual value of its assets and is usually calculated once a day, at the close of the New York Stock Exchange at 4 p.m. ET. (Exceptions include closed-end funds and exchange-traded funds, which are priced continuously throughout the trading day.) At that time, the value of a fund's securities and cash are totaled, and management fees and other expenses are deducted. That figure is then divided by the number of outstanding shares in the portfolio. And while that NAV will increase when the fund has positive returns, it will also decrease when it pays out dividends or makes capital-gains distributions. A fund will drop by the amount of the dividend or distribution, which accounts for many declining NAVs -- and puzzled investors -- each autumn.

Although stocks are often purchased in round lots, investors usually buy fund shares in dollar-based increments, which means the size of a fund's NAV plays a negligible role. Instead, what you need to pay attention to is the minimum initial investment (i.e., how much you have to shell out to get started). Want to begin investing in the Vanguard 500 Index fund (VFINX)? That requires $3,000, which would have bought you 26.954 shares based on Tuesday's NAV of $111.30.

Also unlike stock prices, NAVs are useless for comparing funds. Consider that the Vanguard 500 Index fund, at that $111.30 NAV, has a five-year annualized return of 14.28%, while the California Investment S&P 500 Index fund (SPFIX) has a $24.17 NAV and a five-year annualized return of 14.34%. Very similar funds -- both even have extremely low expense ratios -- but their NAVs differ dramatically. So when it comes to funds, investors should focus on returns, not NAVs.

This is also why investors shouldn't be swayed by fund splits, which are on the rise even though they're still nowhere near as common as stock splits. While a stock split makes the stock more affordable to more investors -- and can sometimes signal increased optimism on the part of management -- a fund split only lowers the NAV. And since fund purchases are made in dollar amounts rather than whole-share increments (you can always buy fractional fund shares), that lower NAV doesn't mean much. Nevertheless, a low fund NAV can be appealing, says Ramy Shaalan, senior fund analyst at fund tracker Wiesenberger, for the same somewhat irrational reasons that splits seem to make stocks more attractive. For some folks, it's just more satisfying to own, say, 100 shares of the Fidelity Dividend Growth fund (FDGFX), instead of 50 shares.

Now, as far as your wife's belief that prices don't matter since it all evens out in the end -- she's right -- that is, if you're using dollar-cost averaging. If you make regular fixed-amount purchases of a certain fund, your average share price will indeed even out over time. It's also a great strategy for buying low and selling high, since you'll be buying more shares when prices are down, and fewer shares when prices are higher.