Have you ever had really good pie? Like a classic apple pie. As much as you want the whole pie, you have just one slice, since that new trendy diet you’re trying is telling you no. Similarly, perhaps you want to buy a share of an expensive stock, for example Amazon at around $3,000, but your wallet is screaming “no”. Instead you buy just a piece of the company’s stock, or a fractional share, based on the amount you want to invest.
Fractional shares are exactly what they sound like – they are portions of a whole share. Originally, fractional shares were the result of mergers and acquisitions or stock splits, when the particular mechanics of such activity resulted in some investors holding an uneven portion of the company. That still happens occasionally, but nowadays many brokers specifically offer fractional shares as a financial product to make investing more affordable and accessible to everyone.
Like the automation of stock trading, fractional shares are just another extension of the increased accessibility of the stock market.
What is the history of fractional shares?
Not so long ago, during the age of mullets and corded phones, if you wanted to buy shares of a company you had to call up your broker on the trading floor. After telling them the company ticker (a nifty little code used to identify a stock), how much stock you wanted to buy, they would then head over to the trading pit and almost wrestle other traders to get your order in. If your broker was successful, you would be the proud owner of a piece of a public company.
Thanks to some clever people with computers, that chaotic method of transacting was replaced by electronic trading systems that have automated the process of price discovery. Now there are fewer shouting people and more data servers. You can swiftly buy and sell shares with the click of a button or tap of a screen.
One of the first things electronic trading systems allowed for was narrower share price trading. Before, it was too complicated to trade at smaller price increments and you were only able to transact at even-eighths, meaning the smallest price movement of a stock was $0.25. But with computers, smaller decimal points became possible. That means that as spreads (the price between the cost of buying and selling) have tightened, trading stocks has become even cheaper.
What are the advantages of fractional shares?
There are various advantages to purchasing fractional shares. Fractional shares:
- Are useful if you have a limited amount of capital or if a stock price is too high and doesn’t fit your investment criteria.
- Give you a viable option of buying fractions of more companies with the same amount of money (which as we’ve said before regarding diversification is a key way to reduce risk).
- Allow you to buy as little as one thousandth of a share; others can only be bought through a stock split.
- Some even pay dividends, so you will still be able to take advantage of any available cash flow — but only a fraction of it, of course.
How do fractional shares work in practice?
Let’s say you’re looking to buy your first shares as you begin your investment journey. You’ve got $1,000 to invest and you’ve heard that FAANG stocks are a good place to put your money to work. Before fractional shares became widely available to trade, smaller investors were only able to afford penny stocks, which are known for massive volatility and tendency to be associated with securities fraud. But now you’ve got access to everything with fractional shares.
Sorting through the stocks, you start with Facebook. Great, you can afford a couple of shares. But then comes Amazon (the whole crisp apple pie we mentioned earlier), which as of writing, has a share price of over $3,000. If your broker allows fractional shares, you could buy a portion of a share, allowing you to participate in the massive growth of this large-cap company – up 69% year-to-date.
If you want to get exposure to a handful technology stocks, you could just make it easier on yourself and look into buying fractional shares of a tech-focused exchange-traded fund (ETF).
Can fractional shares help mitigate risk?
Fractional shares are also a powerful way to mitigate risk. It’s good practice for investors to ensure that no single investment exceeds a specific percentage of their total liquid capital – up to 5% being a commonly recommended figure.
If you are only able to trade in single share increments, the risk across your portfolio might not be evenly distributed since each stock trades at a unique price. Buying fractional shares allows you precisely define how much you want to invest, allowing for greater dollar-cost-averaging symmetry.