Fractional shares have proven to be an important innovation for the finance industry, namely online investing. When you think of a share, such as one stock of Apple (NASDAQ: AAPL), you likely think of a whole share. Each whole share, in turn, can be thought of as a slice of the company and its equity. Sometimes even one share is simply too large for an investor. Consider Apple, which is currently selling for roughly $180. With fractional shares you could buy a “slicee” of one Apple share, say 1/3rd of it, which would be worth roughly $60.
Fractional shares become more important the more valuable the individual stock. For the lowest valued stocks, penny stocks, fractional shares might not make much sense. If a stock only costs a quarter, why divide it up further? With moderately high-priced stocks, e.g. AAPL, fractions start making more sense. Fractional shares are especially useful with very high valued stocks. Consider Berkshire Hathaway (NYSE: BRK.A), the holding company run by Warren Buffet. Right now, BRK.A shares are trading for over $300,000 a piece!
Warren Buffet is clearly among the greatest investors in history, yet few people can afford to buy even a single share of Class A Berkshire Hathaway. However, with fractional shares a trader could opt to buy a much smaller slice, say 1%. This way, the cost would be closer to a much more reasonable $3,000.
Fractional shares allow people to invest in expensive stocks that they otherwise would not be able to, thus increasing opportunities for many investors.
Fractional shares are often the result of stock splits, dividend reinvestment plans (AKA DRPs), and other corporate activities. Historically, it has been difficult to acquire fractional shares through traditional markets. However, an increasing number of brokers are now making it possible. The lower price point has opened the doors for more potential investors.
Why We are Hearing About Fractional Trading Just Now
Compared to traditional trading, fractional investing has only recently become popular. Up until recently, the technology and infrastructure simply didn’t exist. Dividing up shares adds some inherent complications, such as tracking ownership. As online training and online stock brokers have proliferated and grown, this created an opportunity for some of them to begin offering fractional shares.
Market conditions have also provided much tailwind. Many of today’s hottest stocks are now very expensive. A single share of Google’s parent company Alphabet costs well over $1,000. Amazon (NASDAQ: AMZN) is trading north of $1,500. Netflix costs roughly $400. This is making it more difficult for less wealthy investors to invest.
Indeed, only about half of all American households are investing. High entry costs can be a difficult barrier for would-be investors to overcome. Stock market participation is even lower for millennials, with 3 in 5 lacking exposure to markets. Fractional shares, however, enable just about anyone to trade with the money they have. As Stockpile Avi Lele put it:
“People are told all the time, ‘Start early, diversify and do it for the long haul,’ but it’s really hard to start early when you’re young because you don’t have a lot of money and you certainly don’t know anything about the market. They don’t teach it to you in school and you can’t walk into a traditional brokerage saying, ‘Hey, I’ve got $50 bucks, how does the market work?'”
One of the best aspects of fractional trading is that they allow risk-averse investors and those unfamiliar with markets to test the waters. Before that, a millennial investor looking to build a portfolio with Amazon, Apple, Google, and Netflix would have to save up thousands of dollars. Now, that very same investor could get starting with $50.
How It Works from the Brokerage Side
Traditionally, investing was relegated to whole units. With a fractional share, a single share or other asset is divided up and distributed among purchasers. You can simply set the dollar amount you wish to invest, and your broker will invest that amount.
Fractional shares were used as parts of dividend reinvestment plans. So if a stock paid out a dividend to you, the company could reinvest that payment (or a portion of it) into fractional shares. This was an obvious application as dividends will rarely provide enough to buy whole shares down to the dollar. Since brokers weren’t needed, this kept costs low.
Next came dollar cost averaging, or buying a fixed dollar amount of a stock regardless of its price. Often, dollar cost averaging plans are set on schedules, with set amounts of money invested at predetermined times . Quite simply, you get what you pay for. If you pay for 1/10th of an Apple stock, you get 1/10 of the equity of that stock. Let’s look at how the broker would execute such a trade.
- First, let’s say a client orders .25 shares of AAPL.
- Next, the broker will execute this trade. The broker could purchase the stock and simply sell you a slice, distributing the equity.
- Or, the broker could wait until more orders come in, say one more .25 AAPL share order, a .20 order a .15 order, a .10 order and a .5 order.
- This is referred to as an execution algorithm and is compiled automatically.
- The algorithms are quite flexible and can handle varying amounts of shares. The shares are compiled into a block order and executed.
- Finally, equity is divided up accordingly
- Broker may wait for more of the similar orders of the other clients (Execution Algo)
- Broker creates a Block Order of a whole number of shares sufficient to satisfy all Client Orders and executes
- Upon execution the assets are allocated to the Client’s Accounts.
Fractional Shares Are Fantastic For Digital Advisors
We mentioned that an increasing number of brokerage platforms are offering fractional shares investing. Not all of them are, but more and more firms are realizing the importance of it.
For digital advisors aka robo advisors, fractional shares are especially important. As such, the most advanced robo trading platforms also allow for fractional investing. Why? There are several reasons, so let’s dig in.
Great For Diversification
Fractional shares make it easy to diversify, even if you only have a small amount to invest. Let’s say you want to invest $1,000. Unfortunately, that won’t buy you a single share of Google. Even if you invest in cheaper stocks, you’d be lucky to pick up more than 10 or so attractive stocks.
With fractional shares, you can diversify down to the last penny, investing your money exactly where you want it. For automated investing, this diversification can help to lower risks while increasing profit potential over the long run.
Give Investors Flexibility
Let’s say you have set up a number of algos to monitor a wide range of stocks. If you were forced to buy whole shares, you’d have to set aside enough money to buy those shares at the targeted price. However, with fractional shares you can set aside a budget instead.
Consider Amazon (NASDAQ: AMZN), which is currently selling for ~$1,700. Let’s assume that the company is going to release their quarterly report, and you think the news is going to be bad. You predict that AMZN will drop to $1,300 and at that price you’re confident that it’s a good deal. You want to set up a robo trader to monitor for the price drop in the hour after the report is released. However, you don’t feel like setting $1,300 aside to cover the trade, as it would pull too much money away from other trade opportunities.
So, you use fractional investing, and then set aside $500. Your prediction proves right, Amazon’s shares drop and your algo executes the trade, netting you $500 worth of a $1,300 Amazon share.
Put All of Your Money to Use All of the Time
Finally, with fractional shares you don’t have to wait until you have enough money to buy a whole share. For example, if you want to buy stocks of Amazon, but only have $100, you can buy a fraction of an AMZN share. This way you don’t have to wait until you save up $1,500.
Fractional Trading Is Great For Newer Investors as Well
Fractional shares offer another benefit. They are a great way to get started with investing even if you don’t have a lot of money or don’t want to risk a lot of money. Let’s say you’ve been studying stock trading and have formulated several strategies that you are confident in.
Using these strategies and insights, you have identified a portfolio of companies that you would like to invest in. For the sake of our analysis, let’s assume that you want to invest in Google (NASDAQ: GOOG ~$1,100), Apple (NASDAQ: AAPL ~$180), 3M (NYSE: MMM ~$240), Goldman Sachs (NYSE: GE ~$270) and United Health (NYSE: UNH ~$230).
There’s a problem: buying one share each of those companies will cost you about $2,000 dollars, with over half of your money being sunk into Google alone. Not only is this a considerable amount of money, but the portfolio will be heavily weighted with GOOG, and you’d prefer to invest 20% of your money in each stock. This will make it difficult to test your strategies. With fractional shares, however, you could take $1000 dollars and then invest $200 in each the above companies.
Fractional Trading is an indispensable part of modern online investing.
When choosing a broker or a digital advisor platform, check if they offer fractional shares trading functionality. Even if you don’t use fractional shares trading in the near future, you may find this functionality useful as your portfolio and investment strategies evolve. Contact ETNA to learn more about how we help online broker-dealer and digital advisor startups to launch fractional shares trading.