Fractional Shares Explained

It’s safe to say that most investors want to invest in high-quality businesses.

But, accomplishing that goal isn’t always so straightforward. The most significant barrier to entry in this regard is quite simple – high-quality stocks are often very expensive. To invest in say Google or Amazon, an investor would have to set aside more than $2,000 – and that’s just for a single share. 💷

This is where fractional shares come in – like shares, they represent a unit of ownership in a business, but a unit that is less than one entire share. They aren’t available via all stock brokerages – but once you learn more about them, the ability to trade them might just become an important selling point.

Fractional shares allow investors to diversify their portfolio by attaining more exposure to various blue-chip stocks, but at a fraction of the price that would otherwise be necessary. However, it’s not all roses – like most things when it comes to investing, fractional shares have both advantages and disadvantages that must be carefully considered.

And though they might not be as straightforward as regular shares, fractional shares are particularly worthy of consideration in these past couple of years – after all, the very blue-chip stocks that can be purchased this way are the most likely to weather the recent geopolitical and economic landscape.

Even though they fulfill a very particular niche, fractional shares aren’t receiving the attention that they’re due – but we hope to change that with our guide. We’ll start with the very basics – what fractional shares are, how they work, and how to invest in them – before moving on to more concrete topics such as tips, examples, and advantages and disadvantages.

Let’s dive in. 👇

What Exactly is a Fractional Share? 📙

Although fractional shares are a relatively recent thing as far as retail investors are concerned, they have been around for quite some time. To answer the question of what exactly is a fractional share, we have to take a look back at a very basic question – what is a share?

A share, in essence, represents equity, a stake, or in plain English a percentage of ownership in a particular business. A fractional share represents the very same thing – just smaller than one entire share.

Fractional shares can come about in a variety of ways – via stock splits, reverse stock splits, mergers, or dividend reinvestment plans. While most of these avenues are outside of the control of regular investors, the ability to purchase fractional shares directly via a brokerage is becoming more and more mainstream. 

In fact, if you’ve already opened an account with a broker, you might already be in a position to buy fractional shares without knowing it. To boil everything down to the very basics – a fractional share is a portion (a fifth, a third, a half) of a single share.

Investors still receive all the benefits of ownership (percentage returns and capital appreciation, dividend payments) with the possible exception of voting rights – that last part is entirely up to the brokerage, as the SEC doesn’t mandate that fractional shares must come with voting rights.

Understanding Fractional Shares 📚

Unlike most other assets, an investor can end up owning fractional shares by chance. Understandably, this can prove to be quite a surprising experience – so let’s take a look at the scenarios that can lead to such an outcome.

Stock Splits 👥

Depending on the financial trajectory of a business and the wider state of the market, a company can elect to change the number of outstanding shares available to investors. This can happen either by a stock split, which increases the number of outstanding shares, or via a reverse stock split, which achieves the opposite (reduces the number of outstanding shares).

Stock splits and reverse stock splits are interesting phenomena that can either be a good sign or a bad sign pertaining to a company’s state, but we won’t be covering that in this guide. Instead, we’ll use a hypothetical example – but one that might easily end up occurring.

Tesla’s meteoric rise to success is hard to ignore – but it has led to one unexpected occurrence. The stock is now so expensive that many retail investors can’t afford a single share. To remedy this, Tesla underwent a stock split – a 5:1 stock split, to be exact.

This means that for every single share of Tesla owned, investors would receive five shares. The total worth of the shares would stay the same – but the entry barrier for purchasing a single stock would be dramatically reduced.

And it worked – the first time that Tesla did a stock split, investor confidence and stock trading volume shot up. So, what does this have to do with fractional shares? It’s simple – not all stock splits are even and neat.

For example, 3:2 stock splits are not unheard of. In March, the W.R. Berkley Corporation, a stock with good long term prospects underwent a 3:2 stock split and announced the institution of a regular quarterly dividend. For every two shares that were previously held by investors, they would receive 3 shares.

In a hypothetical example, an investor who had 4 shares would have received (4:2) x 3 = 6 shares. But an investor that held 7 shares, for example, would have received (7:2) x 3 = 3.5 x 3 = 10.5 shares, or in other words, ten whole shares and an additional one half of a share – that is, a fractional share.

Reverse Stock Splits 📉

Reverse stock splits work in the exact same way as stock splits do, but they decrease the number of outstanding shares. There are a variety of reasons why a reverse stock split might be attempted – and while most of them point to trouble, that isn’t always the case. 

While reverse stock splits are incredibly rare, some companies resort to this measure to raise the trading price of their shares. Booking Holdings (BKNG) is known for using this method to boost their share price in earlier history, and are among the companies projected to initiate another split this year.

General Electric underwent a 1-for-8 reverse stock split in mid-2021. For every eight shares owned, investors would now own one share. So let’s use another hypothetical example – an investor that owned 100 shares when the split occurred would have received 100/8 =12.5 shares after the split was completed.

In another example, a company in the struggling Chinese education sector, New Oriental Education & Technology Group underwent a 1:10 reverse stock split – for every 10 shares held up to that point, investors would receive one share.

An investor that had 440 shares would have ended up with 44 shares after the reverse split. If an investor had 324 shares when the split occurred, they would have ended up with 32 shares, and 4/10ths of a share – in this case, they would have a fractional share.

However, keep in mind that both in the case of stock splits and reverse stock splits, companies might opt to disregard fractional shares altogether and simply pay out cash in lieu of fractional shares – unfortunately, that cash is always taxable.

Dividend Reinvestment Plan (DRIP) 📜

Dividend reinvestment plans (DRIP) are the most common way by which fractional shares appear. A DRIP is the cornerstone of any serious dividend investing strategy – it operates by taking the dividend payments that are due to an investor, and automatically using them to purchase more shares of the company that is paying the dividends.

A DRIP can be a very useful part of an investing toolkit – it is a great way to reinvest money, increase passive income, and most of the best stock brokers offer this feature. Since 1926, dividends have contributed approximately 32% of total return for the S&P 500. That’s a hair’s breadth away from an entire third of its average stock market return.

Let’s use an example that incorporates dividend reinvestment programs. Valero Energy Corp (NYSE: VLO), a transport fuel and petrochemical production company that has seen good growth in recent years, (and happens to be San Antonio’s largest company) has an annual dividend yield of around 4% as of April 2022, and a share price that’s hovering around $100.

If an investor had 5 shares of VLO worth $500, then the annual dividend income that they would be due would be 4% of $500 – that is to say, $20 to be precise. If that same investor were enrolled in a DRIP, that money could be used to buy one-fifth of a regular share, for a grand total of five full shares and one fractional (0.2) share. 💸

That share would then rake in an additional 4% of its dollar value as a dividend: 4% of $20 = $0.8, which would then lead to a $20,8 annual dividend income, with the assumption of ceteris paribus.

As an added bonus, DRIPs are commonly associated with a couple of benefits, such as discounted stock prices.  Keep in mind, however, that you should avoid enrolling in DRIP for stocks that are currently overvalued – in that case, investing the dividends in another stock that has better prospects is the wiser approach.

Although they don’t support automatic reinvesting, a lot of mutual funds allow capital gains distributions to be reinvested – this can also easily lead to fractional shares, although the tax implications of capital gains distributions make it a far less appealing option when compared to DRIPs.

Mergers and Acquisitions 🏦

When mergers and acquisitions occur, two companies combine their stocks. This new common stock is created by using a predetermined ratio – and investors often end up owning fractional shares once the merger is complete. 

If two companies merge or one acquires the other, for example, and a ratio of 4:3 is determined, investors will receive three new shares for every 4 old shares that they own. If an investor owns a number of shares that isn’t divisible by 4, they will end up with fractional shares.

Let’s once again use an example – in March of 2022, Microsoft acquired Nuance, a company specializing in conversational AI. We won’t go into the actual details of the deal, that is beside the point – but this can be used to illustrate how fractional shares arise from acquisitions.

An investor that owned 17 shares of Nuance, using our previous ratio of 4:3, would receive 3 shares of Microsoft for every 4 shares owned. In this scenario, this would leave our hypothetical investor with 12 whole shares and one-third of a share. 

The same would hold true if a merger were to have taken place. Just as in the case of reverse stock splits, a company may elect to offer cash in lieu of fractional shares.

Fractional Shares: How Do They Work? 👷‍♂️

As a relatively unknown topic, fractional shares can easily seem arcane and complicated – particularly for beginners. The entire thing isn’t made any easier by the fact that it is so deeply tied to mergers, stock splits, and dividend reinvestment – all of which are complex and intricate on their own. As an added difficulty, fractions remind most people of math – yet more complexity.

But with just a little effort, an investor can start getting the hang of things – and we promise that it isn’t nearly as complicated as it seems. To illustrate the most important points, we’ll use a couple of examples.

We’ve covered how an investor can end up owning fractional shares (beyond simply buying them), but now two even more important questions remain – how do they work, and how should they be invested in?

We’ll cover the investing strategies down below – for now, let’s focus on the basics of how fractional shares work. Thankfully, the answer to this is one is simple – in most respects, fractional shares function just the same as regular shares do.

The most important thing to note is that while they allow good diversification, fractional shares by themselves aren’t any less risky than conventional shares. The same percentage gains and losses still apply. 

There are a few differences though, but nothing major – these shares cannot be held without a stock brokerage, might experience some issues with liquidity, and are best utilized as long-term assets – but we’ll go into more detail about those topics when we come to tips and strategies. 

How to Invest in Fractional Shares 🏗

To invest in fractional shares, the first thing that an investor has to do is open an account with a good, reputable stock trading app. There are various factors to consider when choosing among the best available brokerages – issues like fee structure, breadth of investment offerings, customer support, platforms, usability apply as they usually do – but first things first, one has to find a brokerage that supports the purchasing and selling of fractional shares.

That shouldn’t be too difficult – a lot of the best stock brokers have begun including this feature in their offerings as of late. We’ll include a short list here, along with links to dedicated reviews and a quick summary of the brokers’ main selling points.

And many others support fractional share trading. The next most important item on the list is fee structure and commissions – because fractional shares allow for frequent purchases, ideally, investors should seek out brokers that don’t charge a flat commission per transaction. In third place, one should factor in what stocks and funds can be purchased using fractional shares.

After that, trading platforms, mobile app support, and the other factors should be taken into account. Once an account is opened and funded, it’s simply a case of finding the stock and deciding on how much money to invest.

Are Fractional Shares Really Worth It? 🤔

Before we move on to actionable advice, concrete examples, and the advantages and disadvantages of fractional shares, let’s deal with the most pressing question regarding this topic – are fractional shares worth it, all in all?

To cut to the chase, we’d say that they are – and of course, we’re not going to leave you with just that – there are arguments to support our point. But first, let’s take care of a smaller yet relevant question – who shouldn’t invest in fractional shares?

The fact of the matter is, the adoption of fractional share trading as a standard feature among most top stock brokerages is on the up – but there’s still a ways to go. Transferring your portfolio from one account to another is a pain even when regular shares are in question – and this is even more pronounced with fractional shares.

If you’ve already chosen a brokerage, and are satisfied with the services that you’re getting, opening another account or transferring your portfolio probably isn’t worth the hassle.

However, if you’re still window shopping for a brokerage, or have already decided to make a switch, the ability to trade fractional shares is a nice bonus. For starters, these shares allow investors to diversify much more easily – fractional shares of stocks and ETFs are probably the most affordable way to ensure proper diversification.

With fractional shares, investors can make full use of the benefits of stock ownership, such as capital appreciation and dividend payments, with far smaller investment requirements. Keep in mind that returns are relative – if a stock’s price appreciates by 10%, investors will get 10% of their initial investment as returns – whether that initial investment is one share worth $10, or half a share worth $5.

Tips to Know Before Investing in Fractional Shares 📝

Now that the basics are out of the way, let’s focus on something a bit more advanced. While investing in fractional shares mostly works the same as with regular shares, there are a couple of tips, strategies, and questions that should be kept in mind to maximize the odds of success.

Risk of Losing Money is Not Reduced ⚠

Investing in fractional shares is not a surefire way of reducing risk. Although it takes much less money to invest in fractional shares, all of the gains and losses that an investor can experience are proportional – a 50% loss is still a 50% loss.

Still, investing only a couple of hundred dollars into an expensive stock via fractional shares instead of spending potentially more than $2,000 for a single share does limit the amount of money that can be lost – but it likewise limits the returns that an investor can see.

As far as the ratio of risk to reward goes, fractional shares should be treated just the same as regular shares. All of the regular rules regarding fundamental analysis, long-term prospects, volatility, and trading volume still apply.

Most Effective When Used With Index Funds 💰

As we’ve discussed, fractional shares make investing in various high-cap stocks much easier. Because of this factor, ensuring proper asset allocation and diversification is also simpler and more convenient to achieve.

However, even though fractional shares make these processes easier, that doesn’t mean that they should be the basis of a diversification strategy. Knowing how to invest in stocks is a skill, and it takes a lot of effort – fundamental analysis, due diligence, financial statements, technical analysis – all of that has to be taken into account. Now multiply that by 10 or 15 – that’s way too much work.

The best way to use fractional shares is in conjunction with index funds. These passive, low-cost funds are the best way to ensure proper diversification, and seeing as how they seek to replicate an index, checking whether or not they succeeded in that goal in the past is quite easy.

Fractional shares allow investors to gain exposure to companies they find promising, which is a good approach to take after a good portfolio with decent risk-adjusted returns has already been constructed. On top of that, it is possible to invest in many ETFs and index funds by purchasing fractional shares of the funds themselves.

One shouldn’t rely on fractional shares as a primary means of diversification. A broad index fund will ensure that an investor is exposed to all sectors and industries in an efficient way. Fractional shares can and should be used to add investments in high-cap growth stocks, like expensive tech companies, on top of index funds and ETFs.

Dollar-Cost Averaging as an Investment Strategy 💵

Dollar-cost averaging is a strategy that is particularly well-suited to beginners and investors with limited budgets. In essence, dollar-cost averaging is the practice of spending the same dollar amount to buy stocks each month or at other regular intervals. 

What this ends up accomplishing is that investors purchase less stock when it is expensive, and more when it is cheap, thereby reducing the effect that volatility has on an investment portfolio.

Dollar-cost averaging and fractional shares are like two peas in a pod. If a brokerage does not support fractional share trading, an investor might have to wait an additional month or two before the amount they saved up is enough to purchase a share. 

With fractional shares, investors have much more leeway and flexibility – investments can be made weekly, monthly, or at whatever interval is desired. Keep in mind, however, that dollar-cost averaging works best with long-term, buy and hold investing – so investors should have full confidence in the long-term prospects of a business before committing to this approach.

What Happens if You Switch Brokerages? 🧐

Switching brokerages is, simply put, a pain. This applies even in regular situations, where a portfolio is constructed strictly from “traditional” stocks, bonds, and funds. However, if a portfolio has fractional shares, changing brokerages becomes an even bigger problem.

Most brokerages do not support the transfer of fractional shares. If an investor wants to switch brokerages while holding fractional shares, the only means of going about it is to sell fractional shares and repurchase them with the new brokerage. This is not only time-consuming and a hassle, but it also comes with tax implications and could cause investors to lock in losses.

Before an investor goes about purchasing fractional shares, the terms of use and fine print regarding the brokerage’s policy should be studied in detail. If you are already on the fence about switching brokerages, it is best to hold off on purchasing fractional shares – at least for the time being.

Fractional Shares as a Long-Term Strategy 🗓

As it is with traditional shares, so it is with fractional shares – in most cases, and for a vast majority of investors, a long-term, buy-and-hold approach offers the best mixture of risks and returns.

To put it bluntly, short-term trading is difficult. It is a hands-on approach that requires knowledge of technical analysis, stock chart patterns, and possibly complex stock analysis software. On top of that, fee structures and commissions mean that high-frequency trading and the affordable price of fractional shares make for a lousy combination that results in high fees.

In comparison to this, fundamental analysis, passive investing, and holding fractional shares for a long time is much easier and avoids all of the aforementioned pitfalls. If an investor has the skills, time, and means to perform proper stock research and due diligence, fractional shares are a great tool for long-term investing.

In conjunction with dollar-cost averaging, they make the process much simpler and easier to execute.

Fractional Shares vs. Penny Stocks ⚔

At first glance, fractional shares and penny stocks might appear similar – primarily in terms of price. However, that’s more or less where the similarities end. First and foremost, penny stocks usually have much laxer listing requirements and suffer from a lack of transparency, while fractional shares belong to companies that must meet strict and rigorous listing criteria.

Another important aspect that differentiates the two is that fractional shares always belong to companies that are listed on public exchanges, while penny stocks can be and often are traded over the counter. While OTC stocks aren’t automatically scams, the OTC market is a popular target of scammers, fraudsters, and other ill-intentioned parties.

In contrast, fractional shares are always legitimate – in fact, a lot of brokerages limit fractional share trading to a very select group of stocks – either very popular and expensive stocks, like Alphabet, Tesla, Amazon, or the contents of the S&P 500.

While fractional shares might be a tad more difficult to sell than regular shares, the issues with liquidity and trading volume are nothing when compared to penny stocks. Penny stocks usually trade at abysmally low volume, until media attention or a famous penny stock investor like Timothy Sykes mentions them. Even when penny stocks do experience high levels of liquidity, the phenomenon is always temporary and accompanied by a large degree of volatility.

Before we move on, we should point out that penny stock trading can be lucrative and worthwhile – however, it requires a lot of diligence, research, and finding a good brokerage for penny stocks. Still, on the whole, fractional shares are much easier to handle – and we’d consider them a much better choice for beginner and intermediate investors.

Pros & Cons of Fractional Shares ⚖

Although fractional share trading for retail investors is a relatively recent phenomenon, a lot of the top stock brokerages are getting in on the action. These brokerages include Schwab, Fidelity, TD Ameritrade, Robinhood, and Interactive Brokers, just to name a few.

Still, there isn’t a one-size-fits-all framework for the brokerages that do support fractional share trading. Certain brokerages support limited order types when buying and selling fractional shares, and the issue of voting rights is likewise left for each broker to decide on its own. On top of that, the brokerages that do support fractional shares usually reserve the feature to a limited amount of stocks and funds.

On the other hand, when available, fractional shares go a long way in helping new investors and those who have limited budgets to diversify, buy blue-chip stocks, reach their desired asset allocation, as well as affording these investors the right to dividend payments. Although fractional shares can be a tad more difficult to sell, they have the same risks and returns that their non-fractional counterparts do.

When considering a brokerage for buying and selling fractional shares, it is important to keep a close eye on its fee and commission structure. The lower price of capital shares allows for much more frequent buying and selling – if an investor is charged for each transaction, those costs can easily pile up and make the entire effort unprofitable.

Although fractional share trading for retail investors is a relatively recent phenomenon, a lot of the top stock brokerages are getting in on the action. These brokerages include Schwab, Fidelity, TD Ameritrade, Robinhood, and Interactive Brokers, just to name a few.

Still, there isn’t a one-size-fits-all framework for the brokerages that do support fractional share trading. Certain brokerages support limited order types when buying and selling fractional shares, and the issue of voting rights is likewise left for each broker to decide on its own. On top of that, the brokerages that do support fractional shares usually reserve the feature to a limited amount of stocks and funds.

On the other hand, when available, fractional shares go a long way in helping new investors and those who have limited budgets to diversify, buy blue-chip stocks, reach their desired asset allocation, as well as affording these investors the right to dividend payments. Although fractional shares can be a tad more difficult to sell, they have the same risks and returns that their non-fractional counterparts do.

When considering a brokerage for buying and selling fractional shares, it is important to keep a close eye on its fee and commission structure. The lower price of capital shares allows for much more frequent buying and selling – if an investor is charged for each transaction, those costs can easily pile up and make the entire effort unprofitable.

Should You Invest in Fractional Shares? 👨‍🏫

Fractional shares aren’t really a hot topic of conversation and are often overlooked. As we’ve discussed, if your brokerage doesn’t support fractional shares as a feature, making the switch usually isn’t worth the hassle and the expense.

However, investors who use brokerages that do support this feature are in luck – in effect, fractional shares allow for more, easier diversification, and significantly expand the horizon of what an average Joe investor can put their money into.

If you can invest in fractional shares, we recommend that you do so. As long as some ground rules are kept in mind, fractional shares can be a powerful part of your overall toolset. 

Due diligence, fundamental analysis, and long-term prospects still apply just the same, or even more – the most significant difference between regular shares are fractional shares is how easy/difficult it is to sell them. In essence, all long term factors have to be taken into account – fractional shares don’t mesh well with short-term trading.

When it comes to fractional shares of ETFs, the constituents, historical performance, and expense ratio should be carefully analyzed – but just as in the case of stocks, these are general steps that investors should take even with regular shares.

So long as everything is done carefully and by the book (with a little added precaution), fractional shares are a great, low-cost way to diversify holdings, reduce the overall risk of a portfolio, and take part in the profits that industry leaders and large companies can bring to the table.

Conclusion 🏁

Thank you for bearing with us and giving us your attention. Although the topic of fractional shares can seem daunting at first, ambitious investors should be aware that they are a great way to diversify a portfolio.

Although not all brokerages offer fractional shares, those that do just might have an edge – fractional shares might require a little more elbow grease, but they provide a great starting point for most novice retail investors.

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