Fractional Shares: Diversify Your Portfolio, Minimize Risk

If you've been eyeing an expensive stock but are hesitant to put all your savings into a single company, fractional shares, offered by some online brokerages, present an economical way to begin investing. Fractional shares represent partial ownership of a company's stock, amounting to less than one whole share. They enable investors to purchase stock based on a dollar amount rather than a fixed number of shares. For instance, if you invest $100 in a stock with a share price of $200, you would own half a share.

Understanding Fractional Shares

Fractional shares can arise from various scenarios, including dividend reinvestment plans, stock splits, and mergers and acquisitions.

Dividend Reinvestment Plans (DRIP)

Dividend reinvestment plans (DRIP) often lead to fractional shares. These plans allow investors to use dividend payouts to acquire more shares of the same stock, with the resulting amount not necessarily equaling whole shares. Capital gain distributions and dollar-cost averaging programs can also yield fractional shares.

Stock Splits

Stock splits may not always produce whole numbers of shares. For example, a 3-for-2 stock split would generate three shares for every two owned by an investor, resulting in fractional shares for those with an odd number of shares prior to the split.

Mergers and Acquisitions (M&As)

Mergers and acquisitions (M&As) can also result in fractional shares, as newly combined companies issue common stock according to a predetermined ratio, often leading to fractional shares for existing shareholders.

Some brokerage firms deliberately divide whole shares to offer fractional shares to clients, especially for high-priced stocks like Amazon (AMZN) or Alphabet, Google's parent company (GOOGL). Fractional shares often provide the only means for individual investors to invest in such companies.

 For instance, a young investor with limited funds may aspire to invest in Amazon but have only $1,000 to start with, insufficient for a full share. In this case, they might seek a brokerage willing to offer fractional shares, enabling them to invest part of their funds in a fraction of an Amazon share and the remainder in lower-priced stocks, where they can afford whole shares.

Reasons Behind Investors Opting for Fractional Shares

Access to Stocks Beyond Budget Constraints

Investing in stocks that would otherwise be financially out of reach becomes feasible with fractional shares. Consider a scenario where a stock is priced at $2,000 per share. To include it in your portfolio, you'd typically need at least $2,000. Buying multiple shares necessitates increments of $2,000 ($4,000 for two shares, $6,000 for three shares, and so forth). If this exceeds your available funds, you'd have to explore other investment options. The challenge of affording the priciest stocks can hinder diversification efforts on a constrained budget. However, fractional shares offer a solution. With fractional trading, you can purchase stock in amounts ranging from $5 to $5,000, regardless of the share price.

Building a Diversified Portfolio

Many sought-after stocks today come with hefty price tags. Constructing a well-diversified portfolio comprising these stocks could demand significant upfront capital. Suppose you have $5,000 to invest. Fractional shares enable you to distribute your funds across multiple companies, irrespective of their share prices. For instance, allocating 10% of your investment to each of 10 different companies would allow you to invest $500 in each, enhancing portfolio diversification compared to consolidating your investment into a single company. This is suitable for investors even with low-risk tolerance.

Maximizing Investment Opportunities

Employing a strategy like dollar-cost averaging, where you contribute a fixed amount regularly to your investment account, often results in uneven stock purchases. Fractional shares offer a remedy to this inconsistency. By utilizing fractional shares in dollar-cost averaging, you can fully invest your cash contributions on a weekly or monthly basis. Without fractional shares, uninvested cash may accumulate until there's enough to purchase a whole share. For instance, if you contribute $200 monthly and the desired stock is priced at $110 per share, you'd only be able to buy one whole share. In the absence of fractional shares, $90 would remain uninvested in your brokerage account.

Drawbacks associated with fractional shares

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Transfer Limitations

Transferring your assets to a new brokerage poses challenges when it comes to fractional shares. While whole shares are typically transferrable with ease, fractional shares may need to be sold to facilitate the transfer, converting them into cash. Depending on individual circumstances, this process could incur tax implications, fees, or other unexpected costs.

Cautionary Advice from Experts

Investment experts caution against allowing fractional shares to divert attention from established principles, such as long-term investing, and may cause behavioral biases. While fractional shares offer accessibility to the average investor, they also present a risk of focusing excessively on short-term gains. Accumulating wealth requires patience and adherence to a long-term investment strategy rather than being swayed by the allure of frequent trading. In essence, the convenience of purchasing fractional shares may tempt investors towards a more active approach in the stock market. However, the reality is that active trading seldom outperforms the strategy of buy-and-hold over the long term.

Investing & Trading in Dividend Stocks & ETFs with Fractional Shares

Yes, dividend stocks are available for purchase as fractional shares. However, the dividend payouts you receive will be proportional to the portion of the share you own. For example, if you invest $25 in a $100-per-share stock with a $1 dividend, your dividend payout would be only 25 cents. Some brokers offer ETFs as fractional shares. ETFs, which are index funds traded throughout the day like stocks, provide an easy way to diversify a portfolio. Investing in multiple ETFs through fractional shares further enhances diversification. In terms of spot trading, the sale of fractional shares can only be facilitated through major brokerage firms, which may consolidate them with other fractional shares until a whole share is obtained. However, selling fractional shares, particularly for stocks with low demand, might take longer than anticipated.

Stock Split Impact on Fractional Shares

Stock splits, which involve a company reducing its stock price while increasing the number of shares outstanding, do not affect fractional shares differently from whole shares. If you own 3.5 shares of a company undergoing a two-for-one stock split, you would then own seven shares, with the total value remaining unchanged.

Real-World Example of Fractional Share Trading

In November 2019, Interactive Brokers became the first major online brokerage to offer fractional shares trading. Subsequently, on January 29, 2020, Fidelity announced its introduction of fractional shares trading for equities and ETFs.

Conclusion

Fractional shares offer a gateway to the world of investing for individuals who may have been deterred by high share prices or lacked sufficient capital for diversified portfolios. While they provide access to stocks that would otherwise be out of reach, there are considerations to keep in mind. Transferring fractional shares between brokers may not be as straightforward as with whole shares, potentially incurring fees or tax implications. Furthermore, it's essential for investors to maintain a long-term perspective and not let the accessibility of fractional shares distract from proven investment principles. Patience and a focus on the big picture are key to building wealth over time.