Investing in stocks can be expensive. This is especially true for several mid-cap stocks and most large-cap stocks. A share in a big tech company like Apple or Nvidia is worth hundreds of dollars. The best option to have a diversified portfolio of stocks at an affordable cost is through retail-focused pooled funds like mutual funds, exchange-traded funds, and unit investment trusts. Another option is through fractional shares.
Buying and Investing in Fractional Shares: What are the Advantages and Disadvantages?
Investors were limited to purchasing an entire or whole share of stocks or exchange-traded funds before. The concept of owning a fraction of a share of a company began in the 1980s and 1990s in the United States as an offshoot of several dividend reinvestment plans. Several brokers during the late 1990s began trading fractions of shares but the scheme did not appeal to investors because the high costs of transaction rendered it impractical.
Nasdaq started allowing the trading of certain third-party products that represented fractional interests in stocks in 2010. The biggest turning point happened in 2019 when brokers like Charles Schwab and Fidelity rolled out fractional shares trading for stocks and various exchange-traded funds. Newer brokers like Robinhood and other discount brokers made fractional shares a core part of their platforms to appeal to younger investors.
Pros of Fractional Shares
A fractional share represents less than one full share of a stock of a company or an exchange-traded fund. This means that it allows an investor to invest without purchasing and owning an entire share. The availability of fractional shares as an alternative to purchasing whole shares also enables access to high-priced stocks. The following are the specific advantages of fractional shares:
• Lowers Entry Barrier: The availability of fractional shares makes investing in stocks and even exchange-traded funds more affordable. This also means enabling individuals with limited dispensable cash to access sought-after stock markets like in the United States or publicly traded companies with growth potentials or value characteristics.
• Increased Diversification: Investors are encouraged to build diversified portfolios through accessible and affordable investing options. Fractional shares give them more choices and enable them to spread their investments across different companies and under different industries for a fraction of the cost. This helps in reducing their overall risks.
• Dollar-Cost Averaging: Another notable advantage of investing in fractional shares is that it complements the principles of dollar-cost averaging. This investment strategy involves investing a fixed amount at regular intervals and enables an investor to buy and acquire more shares at a good overall price over a period despite price movements.
• Compounding Potential: The affordability of this investment option and its support for dollar-cost averaging also create compounding potential. Fractional shares encourage a particular investor to enter the market as early as possible and start benefitting from compounding returns quicker through regular investments at regular intervals.
• Fractional Benefits: Investing in fractional shares can also provide investors with several privileges available to owning whole shares of common stocks or preferred stocks. For example, when it comes to purchasing and owning fractional shares of dividend-paying preferred stocks, investors can also receive prorated dividend payments.
Cons of Fractional Shares
It is true that fractional shares allow investors with limited budgets to enter and start investing in stock markets or exchange-traded funds but it is important to note that they come with several drawbacks. Take note that owning fractional shares does not provide the full privileges and benefits of owning whole shares. Below are the specific disadvantages of fractional shares:
• Higher Cost Potential: Some brokerages might charge additional or higher fees for buying and selling or trading fractional shares. This can be impractical and suboptimal if fees eat into returns for small investment amounts. Those who have substantial dispensable money to invest might be better off purchasing and owning whole shares.
• Analyzing Difficulties: Another disadvantage of fractional shares is that they can be more difficult for some investors to analyze using the tools and methods in fundamental analysis or technical analysis. This is true when dealing with multiple fractional positions. The value and price movements of fractional shares are not always similar to whole shares.
• Limited Availability: It is also important to underscore the fact that not all brokers or companies offer fractional shares. The selection is relatively limited compared to whole shares of stocks and exchange-traded funds. Investors might find themselves disappointed upon realizing that there are no other options but to purchase whole shares.
• Restricted Privileges: Owning fractional shares of common stocks does not afford investors voting rights. Note that voting rights are typically determined on a per-share basis. These investors might also be ineligible for certain perks like discounts that are usually provided to whole-share investors. They are also not entitled to stock certificates.
• Overdiversification: The accessibility and affordability of fractional shares can also entice investors to purchase and own small pieces or fractional shares of different stocks. This can result in overdiversification, and it can limit the potential of an entire portfolio because low-performing investments can dilute the gains from better-performing ones.