Finance

What Are Fractional Shares? How Could They Benefit Investors?

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Many high-quality companies have stock prices that are so high that even a single share is unaffordable for many investors. For example, a single share of Berkshire Hathaway costs, at this writing, over $424,000! Even if these companies are “cheap” in terms of valuation relative to fundamentals, it’s hard to buy them if you can’t afford a share. Fractional shares address this problem.

Let’s say, as an example, that you have $10,000 in cash that you’d like to invest in a variety of stocks. That’s a sensible approach, as diversification can help to reduce your portfolio’s exposure to single-stock risk.

So, you get a hankering for burritos and decide that you want to invest in Chipotle stock. You’re amazed to find out that, as of early October 2022, just a single share of Chipotle stock costs over $1,500. Then, your attention turns to car parts and you consider taking a small stake in AutoZone, only to discover that one share of AutoZone stock costs over $2,000!

Taking up 15% or 20% of your account with a single stock isn’t ideal for portfolio-diversification purposes. I guess you’ll just have to avoid companies with high share prices – or will you?

There’s a surprisingly simple solution that can make cost-prohibitive stocks more accessible to account holders of all sizes.

It took a while, but brokers have responded to the needs of smaller investors with a product called fractional shares. Don’t worry, I won’t take you back to fifth grade and quiz you on adding and subtracting fractions. Instead, we’ll ask and answer the question: What are fractional shares?

What Are Fractional Shares?

According to the U.S. Securities and Exchange Commission or SEC, a fractional share is “when you own less than one full share of a stock or other security.”

It’s pretty rare that people are referring to anything other than stocks if they’re discussing fractional shares, though. Stock brokers do offer fractional shares of exchange-traded funds or ETFs, as these trade similarly to stocks.

Think of going to an Italian restaurant when you’re craving pizza. If you’re by yourself, you probably don’t plan to eat an entire pizza. If the restaurant wants to stay in business, they’ll offer individual slices of pizza; likewise, responsive brokers are now offering slices or fractions of certain stock shares.

Thus, like a small slice of pizza, it’s much easier for a small account holder to digest one-tenth of a share of Chipotle or AutoZone stock than an entire share. Suddenly, those expensive stocks aren’t so cost-prohibitive anymore, and now just about anyone can participate in the growth potential of a broad variety of businesses.

Explainer: What Makes a Stock “Expensive”?

A stack that costs $1000 per share is more expensive than a stock that costs $100 per share, right?

Not really. For investment professionals, a stock is “cheap” not because of its share price, but because of its price relative to its fundamentals. A stock with a low per-share price can be expensive and a stock with a high per-share price can be cheap.

For example, if that $1000 stock belonged to a company with high revenue and earnings growth, no debt, and very attractive valuation ratios, an analyst would call the stock cheap, because its price is low relative to its value. If the $100 stock belonged to a company with slack or falling revenue and earnings growth, high debt, and weak valuation ratios, analysts would call it expensive.

Who Should Buy Fractional Shares?

Fractional shares aren’t only for investors with small accounts. They can be useful for portfolios of just about any size.

The SEC is correct in pointing out that “Fractional shares are a way to invest when you do not have enough money to purchase a full share of a particular stock.” Yet, that’s not the only scenario in which purchasing fractional shares would make sense. Even if you have a six-figure portfolio, you still might not want to allocate more than 0.5% of it toward any individual stock. In that case, buying half of a share of a more expensive stock would be an easy solution.

Or, let’s say you’re an adherent of a strategy called dollar cost averaging. This basically means investing a fixed dollar amount in a particular stock (or ETF, etc.) on a regular schedule, such as once per month. You might find it difficult to invest a specific dollar amount in a more expensive stock – but I’ll bet you know where I’m going with this. Just use fractional shares to effectively slice off a piece of a share and voila! You’re now able to invest that exact dollar amount you wanted to (or at least, pretty close to it).

Are Fractional Shares the Same as a Stock Split?

You might have heard about stock splits and think that this sounds a lot like fractional shares. They’re not quite the same thing.

Without delving into the finer details of stock splits, we can just say that these operations are initiated by the companies that issue the shares, not by the brokers that assist you in buying and selling the shares. If a company wants to make its stock shares more affordable, it can enact what’s technically called a forward share split. With this, the proverbial pizza is already cut into slices for everyone – no need to request a purchase of fractional shares from your broker.

For instance, Apple and Tesla have enacted forward share splits multiple times because their stocks went into the $700s, $800s, or even above $1,000. These companies did the slicing and dicing for you, but other companies choose not to enact stock splits even if their shares become expensive. That’s not a problem if your broker is willing and able to let you buy fractions of those pricey stocks.

Where Can You Buy Fractional Shares?

Not every broker offers fractional shares, and you’ll need to contact the customer service department of your broker to determine whether you’re eligible to purchase them. That said, as of October 2022, there are some U.S.-based brokers that appear to offer fractional shares to qualifying customers.

Here’s some good news: Many of the brokers who offer free or lost-cost self-directed trading also happen to offer fractional shares. These include some names that might be familiar to you: Charles Schwab, E-Trade, Robinhood, TD Ameritrade, Interactive Brokers, Fidelity, Merrill Edge, and Vanguard.

Not all stocks might be available for fractional share purchases. Individual brokers may place restrictions on fractional share purchases, such as requiring a minimum account size. Some brokers understand that fractional shares are often geared toward smaller account holders, and will therefore try to be more accommodating in providing this investment option.

If you’re shopping for a broker, look at your options and compare their rules on fractional shares.

Get in on the Action with Fractional Shares

So now, you have the lowdown on an investment product that can help you implement strategies such as portfolio diversification and dollar cost averaging. Fractional shares aren’t just for small account holders, as anybody might opt to mitigate his or her exposure to a particular company (or companies, in the case of a fractional ETF share).

Thanks to some of the more responsive brokers, investors of all sizes can more easily purchase some pricey stocks even when the companies choose not to enact stock splits. It’s a step in the right direction as fractional shares can often make investing more accessible, so feel free to take advantage of the opportunity and try a few stock slices for yourself.

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