How Do Fractional Shares Work?
October 27, 2020 | Joyce Ibrahim
Fractional shares trading has been gaining more and more momentum over the last few years, and understandably so. Only a few years ago, buying into big-name stocks like Amazon or Apple was extremely difficult – if not impossible- for small investors and beginners eager to add these names to their portfolios. In fact, at the time of writing this, a single share of Amazon.com, Inc. is going for $3,235, a price much higher than the average individual investor can afford.
But with more brokerage firms and platforms introducing the possibility to trade fractional shares, small and young investors are now able to own a sliver of some of the world’s most coveted stock, for a fraction of the price.
What are fractional shares?
Fractional shares are slices or portions of stocks and ETFs that don’t amount to a full share of equity. Traditionally, fractional shares weren’t available to buy from the stock market, and brokers only dealt in full share units. However, fractional stock is no new concept. Besides mutual funds supporting fractional share trading, there were still a number of ways you could end up with fractional shares:
- Dividend Reinvestment Plan (DRIP). Through DRIPs, dividend payouts to investors are directly used to purchase new shares of the company, and the process often results in the investor owning fractional shares. For example, if you owned 10 shares in a $40 stock and the annual payout is $0.25 per share, you’d be entitled to $2.50 at every payout. If the stock is still at $40, that’s just enough for 0.625 shares. You would then end up with 10.0625 shares.
- Mergers and Acquisitions. M&As can also result in fractional shares, as companies will generally adopt a certain ratio to combine new common stock.
- Stock splits. Stock splits are primarily used by companies to boost their stock’s liquidity by multiplying their number of shares in the market at a lower price. This is especially true for companies with share prices that widely exceed those of similar companies in the same sector. Usually, the stock split follows a certain ratio as well, leaving investors with an uneven number of shares.
Very recently, online brokerage platforms, such as Robinhood, Charles Schwab, and Fidelity began selling fractional shares, making it possible for small investors to buy big-name stock such as Netflix, Facebook, Google, and Target for as little as $5, in Charles Schwab’s case.
Instead of specifying whole units of shares they want to buy, investors can decide on the amount they want to spend. For example, if you want to buy Tesla stock but can’t spend $413 (currently) on a single share, you can choose to spend $45, making you the owner of 0.1 Tesla stock.
With dollar-based investing, however, a fraction of the share means you earn a fraction of the dividend. So, is investing in fractional shares worth it?
Benefits of fractional shares
Fractional shares are mainly effective to build a more diversified portfolio. A diversified portfolio reduces the risk of losing money, since you don’t concentrate your investment on a single company or sector. And the ability to buy several shares for $1 to $5 dollar each gives investors a selection of more attractive stock than they would otherwise be likely to afford, making fractional shares all the more appealing.
Fractional share trading also allows small investors to start dipping their toes into the wider market. With the price barriers out of the way, small investors don’t have to wait until they have enough to invest in big stock, and can immediately get into the market and benefit from compounding returns early on.
Another benefit of fractional shares is better dollar cost averaging. Through dollar cost averaging, you determine a specific amount to invest regularly. And with fractional shares, you can ensure that you’re making the most out of your money, since you’d be investing the full amount you’re feeding into your account on a regular basis.
Downsides of fractional shares
The main drawback of fractional shares is that they are more difficult to transfer. More specifically, it isn’t always possible to transfer your fractional shares from a broker to another. Instead, brokers will transfer full shares, and sell fractional shares to give you as cash.
And since fractional shares don’t trade as frequently as entire shares, they don’t provide investors with immediate asset liquidity.
Another downside of in fractional shares is that they’re in a reduced selection of stocks. Because willingly trading these shares has only recently become common, many stocks aren’t available for fractional investing. This limits investor’s choice of companies, as opposed to buying whole shares.
Fractional investing, despite offering small investors a low-cost opportunity to diversify their portfolios and step into the wider market, does not come without risks. Because the cost of entry is low, some investors could tend to neglect doing the necessary research for better-informed decisions. Furthermore, without the right knowledge and a sound investment strategy, it’s even riskier to buy shares in individual companies, even if they’re only partial stocks.
But with the right strategy and guidance, fractional shares could give you a chance to select investments that truly interest you and that have good potential to outperform the market.
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