I’ve been hearing about fractional shares as a way to invest in the stock market. Can you explain how they work?
No question, the world of investing is overrun with a gazillion tools and products, many of which are either indecipherable or irrelevant to the average investor. But every once in a while, we can welcome the arrival of a new product—like fractional shares—that can actually make investing more accessible.
So thank you for your question. For the benefit of other readers who may not have heard about this new addition to an investor’s toolbox, let’s first take a look at what fractional shares are and how they work, and then go over some of the best ways to put them to practical use.
The new kid on the block
Fractional shares are exactly what they sound like: a piece (or a ‘fraction’) of a single share of stock.
To put this into historical perspective, it wasn’t all that long ago that stock trades were generally made in ‘round lots’ of 100 shares. If you ventured into the world of ‘odd lots,’ or anything less than 100 shares, you paid a higher fee. Eventually, as trading costs continued to drop, it became common for investors to trade as little as a single share.
For many years that sounded pretty good, unless you were interested in owning a stock in a pricey company (like today’s Amazon, Alphabet or Apple). A single share of any of these companies’ stocks runs in the hundreds or even thousands of dollars, putting them well out of reach of many investors.
Enter fractional shares. Now, suddenly, the price barrier is removed. With just the click of a mouse you can buy or sell a sliver of a share—and begin your journey as an individual stock investor.
A few mechanics
Because fractional shares are new, not every brokerage company offers them, and you will likely find different offers. In general, though, this is how it can work: If a company’s stock is selling for $1,000 per share and you invest $200, you would own 20 percent of a share. Or you could spread out your $200 among several stocks. As the share prices move up or down, the value of your holdings will also change proportionally.
In general, many brokerage, traditional IRA, Roth IRA, Coverdell IRA and UTMA/UGMA accounts will all allow you to trade fractional shares. At least for now, it's unlikely that you’ll be able to buy or sell fractional shares in your 401(k) or a 529 College Savings Plan.
Fractional shares as an introduction to investing
When we’re first starting out as investors, many of us are advised to purchase a low-cost mutual fund or an exchange-traded fund, which is great for both ease and diversification. But owning and following a specific company like Apple or Tesla is a very different experience than owning a fund, and provides different lessons—from seeing how the share price responds to things like changing market conditions, or new product development or competition. For a new investor, it can also feel more personal to have a stake in a particular company, and spark a lifelong interest in investing.
Fractional shares can help you diversify
Probably the most important lesson for any new investor is the value of diversification. Therefore, as tempting as it may be to put all of our investment dollars into Amazon, Apple or a company that's developing a hot new product, that’s not recommended. It's much better to think of fractional shares as a way to round out your portfolio, using them to diversify without having to spend a lot of money.
Building on the theme of diversification, both novice and more experienced investors can use fractional shares to implement a strategy I refer to as ‘Core & Explore.’ The concept is simple. If you first allocate the majority (say 80 to 90 percent) of your portfolio to a diversified ‘core’ comprised of a broad range of low-cost mutual funds or exchange-traded funds, you can then add a smaller ‘explore’ portion that includes a curated mix of individual stocks.
Dollar-cost averaging can even out market volatility
Fractional shares are also a great tool for a strategy called 'dollar-cost averaging.' This simply involves investing the same dollar amount at a regular interval (perhaps monthly) regardless of how the stock market is performing. The result is that you'll buy more shares when the market is down and fewer shares when the market is high, potentially smoothing out the impact of market swings and reducing your risk over time.
I’m a fan of dollar-cost averaging because it takes the emotion out of investing at the same time that it provides discipline. With fractional shares, a new investor can get started with just a few dollars a month, and then build on that base over time.
A gift that can last a lifetime
Fractional shares can be great for all of the things I’ve discussed so far, and also especially handy for gifting stock to a child. In fact, one of the best ways I know to pique a young person's interest in investing is by giving them a portion of a real company.
Although it may seem ideal if that stock appreciates in value over time, the more important part of the gift is what it can teach. For instance, experiencing losses when the stakes are low can also provide an invaluable lesson. You can use a gift as small as $5 or $25 to initiate conversations about compound growth, mitigating risk through diversification, and the importance of setting goals.
So the next time a child or grandchild has a birthday or special occasion, we can consider giving them some stock in addition to (or instead of) a toy. A gift of first-hand experience and lessons on investing can last a lifetime.
Looking to the future
At its core, investing is about participating in the American and global economies with a view to future growth. Fractional shares can be a great way for new investors to get started on this journey, regardless of their age. But it’s important not to stop there. Fractional shares can provide a great entry point, but we all need to keep reading, learning, and asking questions. The true power of investing takes place over years and decades, not months or days.
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