The valuations of some of the larger companies on the stock market have climbed to epic proportions. Shares of companies like Amazon (Nasdaq: AMZN) and Alphabet (Nasdaq: GOOG) trade for thousands of dollars per share.
This creates a problem for many investors, especially those just getting a handle on the market, who simply can’t afford to shell out $3,000 for a single share of a company’s stock. Having to buy a whole share would force many investors to choose between a single share of a company they want to buy or a diversified group of individual stocks that trade at a lower cost.
That’s why many popular brokerage firms like Charles Schwab, Interactive Brokers, Robinhood, WeBull, and Fidelity have all begun to offer access to fractional shares.
What Are Fractional Shares?
Fractional shares are offerings by some of the world’s most trusted brokers that allow investors to purchase a fraction of a share of a stock, exchange-traded fund (ETF), or index fund rather than a whole share. These offerings give investors who can’t afford an entire single share of a company the ability to participate in these in-demand businesses.
What Is the Difference Between a Fractional Share and a Regular Share?
Before fractional shares became available, if you wanted to invest in a company, you would log into your investment account and purchase at least a full share of stock at the current stock price. If you wanted more, you could always purchase multiple shares, but the purchase had to be in whole shares.
That option is still available, but thanks to several brokers that aim to give everyone the ability to invest any amount they choose, fractional shares are now another option.
The difference between the two is that when you purchase fractional shares, you don’t make your purchase based on the number of shares you would like to own. Instead, your purchase is based on the amount of money you’d like to invest in a company.
For example, let’s say you want to invest $500 in ABC stock and $200 in XYZ stock. Say ABC stock is trading at $45 per share and XYZ is trading at $1,000 per share. In this case, your $500 would result in ownership of 11.11 shares of ABC and your $200 would result in 0.2 shares of XYZ.
How Do Fractional Shares Work?
Publicly traded companies don’t issue fractional shares to the public; all offerings by these companies are issued in whole share amounts. Therefore, it’s impossible to directly own a fraction of a share because fractions of shares simply don’t exist in the stock market.
Instead, when you purchase a piece of a share, you’re buying it from your broker, which still owns that whole share. Your broker then acts as an intermediary, passing along proportionally any price changes and dividend payments.
For example, when a dividend payment is made, your broker will collect the payment on all shares it holds on behalf of those who own fractional shares. Then, the dividend payment is handed down to investors based on the percentage of the share they hold in their account.
Voting rights are another consideration. When you purchase a share of stock, you’re purchasing a small piece of a company, and that piece comes with voting rights. However, because your broker owns the whole share that your fractional shares are based on, they ultimately get to make your vote for you when it comes to important matters like mergers and acquisitions.
Dividend Reinvestment Plans (DRIPs)
Dividend reinvestment plans (DRIPS) have become a commonly-used tool in the investing community. DRIPS automatically reinvest dividends back into the stock that paid them, resulting in the investor owning more shares.
These plans work the same way with fractional shares as they do with whole shares. When you receive your fraction of dividends owned on your fractional share, those dividends are reinvested in the stock that paid them, resulting in a larger ownership within your portfolio.
Stock splits and reverse stock splits are commonplace in the stock market. When these events take place, a single share of stock is split into several stocks with lower values, or multiple shares are combined to make a single share with a higher price.
These events will either reduce or add to the fraction of shares you own. For example, if you own 0.5 shares of ABC and the company completes a two-for-one stock split, you’ll end up with one whole share, since splitting each share in two cuts the value of each in half. On the other hand, if ABC said it was doing a one-for-two reverse stock split, you would end up with 0.25 shares that are now worth twice as much per share.
It’s important to remember that stock splits are cosmetic changes and will not directly lead to a change in the total value of the shares or fractional shares you own, although the underlying reasons for undergoing a traditional stock split or a reverse stock split could lead to gains or declines.
Mergers and Acquisitions
Mergers and acquisitions are transactions that take place when one company purchases or absorbs another. As a result of these transactions, shareholders in the company being purchased or absorbed will receive either cash or stock payments from the acquiring company.
For example, say ABC acquires XYZ for $10 and one share of ABC per share. That means XYZ shareholders receive $10, plus one share of ABC stock, for every share of XYZ they own.
How does that work with fractional shares? Much like with dividend payments, investors receive the shareholder benefits in fractions at the agreed upon price.
In the example above, if you owned 0.5 shares of XYZ, you would receive $5 and 0.5 shares of ABC as a result of the transaction.
Pros and Cons of Fractional Shares
When considering any investment or financial product, it’s important to think about the pros and cons before diving in. Her are the most important benefits and drawbacks to fractional shares to consider.
Pros of Fractional Shares
There are plenty of reasons to be excited about having access to fractional shares. Some of the biggest perks include:
- Access to Expensive Stocks. Fractional shares give investors access to the higher-priced stocks they simply wouldn’t have been affordable in the past. Now newcomers can invest in companies like Amazon.com and Google, regardless of the amount of money they’re starting their investment portfolio with.
- Diversification. Diversification acts as insurance, helping to make sure your entire portfolio doesn’t take a dive if one stock in your portfolio gets hit hard. As a result of fractional shares, investors with relatively small portfolios no longer have to give up diversification in order to own a few whole shares of a handful of stocks.
- Simplicity. Many investors find it easier to invest in companies based on dollar amounts rather than share counts. Not only do these shares simplify the purchasing process, they make balancing asset allocation within your portfolio simpler.
Cons of Fractional Shares
Unfortunately, fractional shares aren’t all sunshine and rainbows. There are some downsides to consider before diving in. The most important of these drawbacks include:
- Giving Up Your Voting Rights. As a shareholder, you have voting rights, but only whole shares get votes. You give up your voting rights on the fraction of a share you own when you buy pieces of stocks instead of entire shares.
- Lack of Direct Ownership. When you own fractional shares, you don’t directly own anything. The shares are owned by the broker you work with, and it becomes your broker’s obligation to share any dividends associated with the piece of the stock you have in your account.
- Uncertainty of SIPC Insurance. All investors who work with regulated brokers have Security Investor Protection Corporation (SIPC) insurance, which would compensate you for losses up to $500,000 if your broker goes out of business. However, because fractional shares are a relatively new concept, the details of how the SIPC would handle them aren’t clear. It’s possible the SIPC would pay investors the cash value of their fractional shares, but it’s also possible that the SIPC would ignore fractional ownership, and your fractional shares may be lost in the event of the dissolution of your broker.
How to Trade Fractional Shares
Fractional share investing and trading works just like trading full shares of stock. You just need to work with a brokerage that offers them.
To take part in fractional share trading, simply log into your brokerage account and trade the stock you’re interested in. Instead of selecting the number of shares you want to buy or sell, enter your orders based on the dollar amount you want to trade.
Fractional share orders execute just like orders for whole shares, but some brokerages fill fractional share orders only at the end of the day.
All told, fractional shares are an exciting tool in the stock market. Thanks to the introduction of fractional shares, you now have access to even the highest priced stocks, even if you only want to buy $1 worth.
However, when taking advantage of these pieces of shares, it’s important to consider the drawbacks. If you like making sure your vote is heard or are concerned that your broker may go out of business, these shares aren’t the best way to go.