Dear Carrie: I’ve been hearing about fractional shares as a way to invest in the stock market. Can you explain how they work?—A Reader
Dear Reader: 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, such as fractional shares, that can actually make investing more accessible.
The New Kid on the Block
Fractional shares are exactly what they sound like: a piece (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 so-called 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 pricy company (such as today’s Amazon, Alphabet, or Apple). A single share of any of these companies’ stock runs in the hundreds or even thousands of dollars, putting them well out of reach of many investors.
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.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 such as Apple or Tesla is a very different experience than owning a fund and provides different lessons including seeing how the share price responds to things such as changing market conditions, new product development, or new competition. For a new investor, it can also feel more personal to have a stake in a particular company, and that can 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.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.A Gift That Can Last a Lifetime
Fractional shares can be great for all of the things I’ve discussed so far and 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 him or her 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 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.