The age old problem with stock investing
Beginner investors today don't know how good they've got it when it comes to investing. Fractional shares have made is easier than ever now, for even those with small amounts to invest.
Things weren't always like this. Even as early as 5 years ago, Wall Street preferred richer investors with larger amounts of money to invest. If you couldn't afford to buy round lots of 100 shares of stocks, some brokers didn't really want to deal with you. That meant coming up with $5,000, $10,000, or even more just to buy a single stock — requiring $100,000 or more to put together a truly diversified portfolio.
The rise of retail investment platforms improved things for small investors, making so-called micro investing of less than 100 shares more common. Inspite of this, investors faced another challenge: sky-rocketing stock prices that meant you'd sometimes need hundreds or even thousands of dollars just to buy a single share of certain stocks.
Investing with small sums of money wasn't easy
For example, investors are dead set on buying a share of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) stock. But the A shares were already well out of most investors' reach, even 5 years ago, at more than $216,800 per share. At the time of writing of this article (July 2021), the A Share is well over $418,000 per share.
However, the Berkshire B shares, which represent 1/1,500 of an A share economically — are around $145 per share. If you want to start you stock portfolio with around $2,000 dollars, its not easy to create a diversified portfolio with such high share prices.
Fractional investing to the rescue
The solution is to make use of new feature on modern investment platforms called Fractional Investing or fractional shares in case of stocks.
Let's have a look at how fractional shares can solve this problem and help you optimize your investment portfolio.
Fractional Shares 101
What is a fractional share?
A fractional share is (as the name suggest) a fraction or part of one unit of a stock -- for example, one-half or one-third of a share. Fractional shares themselves aren't new. They still occasionally turn up in investment portfolios, due to stock splits, mergers, or dividend reinvestment programs. You might own 39 shares of a stock that splits 3-for-2, for example. After the split, you'll have 58.5 shares. That one-half of a share functions like a smaller version of a whole share; it's worth 50% less and earns half the dividends, too.
When did fractional shares start?
What is fairly new is the ability to buy fractional shares intentionally. This capability started appearing in smaller investing start-ups like Robinhood only in the last 2-3 years, under the names fractional investing or dollar-based investing.
The term "dollar-based investing" describes how fractional investing differs from traditional stock buying. Instead of specifying how many shares you want to buy in whole units, you state how many dollars you want to spend. The minimum investment is usually $5. That dollar amount is divided by the share price to calculate how many shares you'll get in the transaction. For example, you could invest $5 in Amazon (NYSE:AMZN). With Amazon's current price per share of $3,626, your $5 investment would get you 0.0014 shares.
What Fractional Shares Let You Do
If you have $100 a month to put to work and you want to buy a $2,000 stock, you can buy 1/20th of a share this month, 1/20th next month, and so on, until you get to your final goal.
The nice thing with fractional shares is that along the way, you get to be a shareholder. If the stock goes up, the value of your fractional share goes up. If it drops, the value will go down — but your next investment will come at a cheaper price, assuming you're committed to making regular investments month in and month out.
With fractional shares, it's also far easier to invest in a diversified portfolio comprising many stocks. If you have $1,000 a month to invest and you want to buy 10 different stocks, you can just tell your broker to invest $100 in each of the 10 stocks. The fractions will work themselves out.
Try that with whole shares of stocks, and at best, you'll usually end up with unequal allocations among the stocks because of their different share prices. At worst, you won't be able to buy some stocks at all because they cost more than your available cash.
You can even dollar-cost average, investing the same amount each month. You'll buy a bigger fraction when stock prices are low and a smaller one when prices go up.
Where can you buy fractional shares?
Fractional investing is in the news today because big brokerages are moving it from the start-up space into the mainstream. Charles Schwab (NYSE:SCHW), one of the largest brokerage firms in the country, and Fidelity's investment platform already offer fractional share investing as of today.
Which Fractional Shares Are Traded the Most?
The five most purchase fractional shares are:
- Microsoft (NASDAQ:MSFT) – over $215 per share
- Apple (NASDAQ:AAPL) – over $495 per share
- Amazon (NASDAQ:AMZN) – over $3,337 per share
- Tesla (NASDAQ:TSLA) – over $1,997 per share
- Netflix (NASDAQ:NFLX) – over $487 per share
Why fractional shares are great for early investors
Charles Schwab, Fidelity and other platforms are showing support for fractional investing, because it delivers four significant advantages to early investors.
- Access to more investment choices: On May 18, 2020, the share price of Amazon (NASDAQ:AMZN) closed at a steep $2,426.26. If you've just set up your budget to support a $100 monthly contribution to your investment account, it would take more than two years to save enough for a single share of Amazon. And that's assuming the share price doesn't change. Even if you had just enough cash for one share today, you wouldn't want to sink all of it into a single stock share. The lack of diversification would be too risky.
With fractional investing, you don't have to save up enough to buy a whole share. You have access to positions in Amazon, Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG), Apple (NASDAQ:AAPL), and other high-priced stocks that would normally be out of your price range.
- Affordable buy-in: Along the same lines, you can start investing with very small dollar amounts. You could choose to spend $10 on Amazon, for example, and that would get you roughly .004 shares at the May 18 closing price.
Depending on the investment platform, you can buy as little as .001 shares at a time.
- Easy diversification: In the old days, diversification required buying 20 or more separate positions, or alternatively leaning on mutual funds. As an early investor, you mostly had to go with mutual funds -- because individual shares were too expensive. That problem disappears with fractional investing. You could build a diversified portfolio for $30 or $40, less than what you might pay for a single mutual fund share.
- Dividend reinvestment: In a small portfolio, your cash dividends might be less than $100 monthly. As a fractional investor, you can immediately put those dividends to work, rather than waiting until they accumulate to a larger amount. The earlier you get your cash invested, the more you can earn on those investments.
Investing on your terms
As an experienced investor, you can use dollar-based investing to invest your cash faster. As a would-be investor, fractional investing can get you in the market, building wealth, with as little as $5 -- an amount you might spend on a latte without a second thought.