Fractional shares are a way for investors to be able to start investing in the stock market despite not having a lot of money to start with. Instead of being forced to buy at least one single share of stock, retail investors are now able to buy a fixed dollar amount of stock, despite not having enough funds to buy a single share.
In this guide, we will go over what is a fractional share, explain how it works with an example, analyze the pros and cons, and answer some of the most common questions investors have about investing in fractional shares.
What are fractional shares?
Fractional shares represent a fraction of a whole share, and that means that investors are able to buy a certain percentage of a whole share or a fixed dollar amount of a share. Before fractional shares were introduced, an investor would be required to have the amount a single share was trading at to be able to invest in it.
With fractional shares, you are able to invest a fixed amount of money or buy a certain percentage of stock. Fractional shares make it easy for investors with smaller portfolios to be diversified and still invest in the companies they want to, despite not having enough money to buy a single share of every stock. Additionally, fractional shares also make it easier to invest a certain amount of money every month or every week in the stocks in your portfolio.
How fractional shares work [Example]
The best way to understand how fractional shares work is with an example. Let’s consider you have a portfolio of $500 and you want to buy a stock trading at $500 a share, but you want to invest in different stocks, and keep a diversified portfolio.
Without the advent of fractional shares, you would be required to have $500 to buy a single share, which would force you to have your portfolio concentrated on a single share. However, with fractional shares, you are able to buy a portion of a single share or a fixed amount of money.
That means that you can invest $50 into the stock, and buy 10% of a whole share. This allows you to keep the exposure to the stock at 10% of your portfolio, while still being able to benefit if the stock moves higher.
Fractional shares easily investors with portfolios of all sizes to be diversified and invest in the companies and ETFs they want. Most investing apps allow you to buy as low as $1 of a stock. This has marked the beginning of a new trend in investing - micro-investing and micro-trading.
Pros & Cons of Fractional Shares
If you are considering investing in fractional shares it is important to analyze both the pros and the cons associated with it.
What are the pros of investing in fractional shares?
1. Start with small sums of money
One of the greatest advantages of fractional shares is that you can start investing with extremely small sums of money. This is especially important if you are young, and you still want to take advantage of the benefits of starting to invest early.
2. Buy in dollars
No longer are you forced to buy a certain number of shares, or even a single share. With fractional shares, you can buy a certain fixed dollar amount that you want to invest in a stock. This is a great alternative for investors who want to add a weekly or monthly dollar figure to their investment portfolio and has several advantages over buying in shares.
3. Great for dollar-cost averaging
Another great advantage of fractional shares is that it allows you to dollar-cost average a certain amount of dollars. For new investors, this is especially useful, because they do not have to commit to buying a certain number of shares, and can frequently add to their positions using a DCA strategy.
4. A simple way to automate investing weekly, monthly, or quarterly
Investors who want to take a passive investing approach are able to automate their investments in a simpler way using fractional shares. Instead of being limited by the price the shares are trading at, they can choose to add a certain amount of money into their portfolio every week or every month.
5. No restrictions when it comes to stock selection
For decades, investors were forced to buy certain stocks that were trading under a certain price, because their portfolios were too small. Not anymore, with fractional shares investors are able to buy the stocks they want without having to worry about having enough funds to buy a single share.
6. Diversified portfolio
Lastly, and perhaps one of the most important benefits of fractional shares is that allow every investor no matter how small their portfolio is to be diversified. It is important to understand the benefits of diversification, and how using fractional shares can help you grow your portfolio over time.
What are the cons of investing in fractional shares?
1. Lower Liquidity
Perhaps the biggest disadvantage of fractional shares is that the liquidity or the number of fractional shares actively traded is a lot smaller than the whole shares. For this reason, you could face some liquidity problems, or you could see a higher spread between the bid and the ask, as well as a smaller bid-ask size.
2. Higher fees
While some brokers do not charge any fees to trade fractional shares, others apply the same fees as if you would be buying or selling whole shares. For this reason, the fees will most likely represent a higher percentage of the whole trade, than if you were to buy or sell whole shares. This is one of the disadvantages of trading or investing in fractional shares, and you should be aware of the fees charged by your broker.
3. Limited voting rights
Voting rights are usually attributed on a per-share basis, and for that reason, if you do own a whole share of a certain company you have no voting rights. This is another disadvantage that you should consider if you are thinking of investing in fractional shares.
4. Some stocks don’t have fractional shares
While fractional shares are available for most large-cap US companies, you cannot invest in every stock using fractional shares. For small and mid-caps, fractional might not be available, and investors should be aware of it.
While fractional shares still receive dividends in some cases the dividend might be far too small to be paid, for example, if it is under one penny. Moreover, the dividends fees collected by your broker could be higher than the dividend itself.
What kinds of investors can use fractional shares?
For retail investors, fractional shares are proving to be extremely popular. Especially among new traders, and people who want a simple do-it-yourself approach to saving and investing.
Though the dynamics are no different than whole shares, fractional shares are somewhat easier to understand from a new investor’s perspective because they deal purely in dollar values rather than in share numbers.
The really powerful aspect of this strategy comes in two primary forms:
- Access to expensive companies and offering investors a cost-effective diversification method
- Allows investors to deploy their capital, even if it is a small sum of money
- Because of the nature of fractional shares, investors don’t need the full amount of a single share in order to own stock in that company
- Reduces the risk of being forced to have a concentrated portfolio, allowing investors to easily diversify across different stocks
Fractional shares have leveled the playing field for retail investors. However, at least one disadvantage seems to be highly dependent on the broker you use. Some brokers still charge transaction commissions on fractional shares. Since retail investors often buy fractional shares with small sums of money the commission might have a large impact on the returns.
How to use fractional shares to your advantage
With the collapse of savings rates across the globe, more people than ever before are turning to the stock market for solutions to their long-term financial goals.
As more investors join the market each year, a high-level analysis attempting to explain this trend might attempt to incorporate the explosion in both the popularity and number of investing apps available for smartphones that have made it easier than ever before for people to participate.
But it may be the mechanism of fractional shares purchases that is providing the fuel for growth in the retail investing industry as this strategy lowers the financial barriers to some of the world’s most valuable companies.
As we outlined above, fractional shares allow retail investors to get access to all of the gains and losses that stock experiences. While at the same time receiving dividends as well as other payments to shareholders. The second advantage, cost-effective diversification, comes into play when you combine this access with a wider market strategy.
Rather than being limited to a smaller pool of affordable investments. Through fractional shares, investors can funnel their money into various companies at varying levels of risk and reward. Allowing them to harness the powers of diversification to shield them from market downturns.
Fractional Shares FAQ
Are fractional shares a good idea?
Despite the few disadvantages fractional shares have, they are generally a very good idea. In fact, fractional shares are one of the best investing innovations in the last decades, becomes it democratizes access to financial markets. While for years people used to think that investing in the stock market was only for the rich, this common investing myth has been long debunked, with the introduction of discount brokers and fractional shares.
Can you make money on fractional shares?
Obviously, investors can make money with fractional shares, either investing in them for the long term or trading them in the short term. Despite not owning a whole share, whenever the stock price rises, the value of your fractional shares will also rise by the same amount.
Do fractional shares earn dividends?
Yes, fractional shares also collect dividends, however, the dividend you will receive will be proportional to the percentage of the whole share you own. So for instance, if you own 10% of a stock that pays a $1 dividend, you will receive $0.1.
Is it hard to sell fractional shares?
One of the biggest disadvantages of fractional shares is the lack of liquidity because they are less traded than whole shares. For this reason, you may find it harder to sell your fractional shares, and you may see a larger bid-ask spread than in whole shares. However, if you invest only in fractional shares of large caps stocks, the liquidity will be higher, and therefore it will be easier to trade those stocks.