by STEVE MARTIN

Everything changed with fractional shares.

While the idea of buying fractional shares of stock has been around for more than 20 years, it didn’t really become a mainstream part of retail investing until recent years. It has made a profound change in the ability of new investors to start buying stocks.

Traditionally, it could be a laborious process to buy shares of stock in companies. First, you had to open a stock brokerage account. Often, brokerage firms had minimum funding requirements, as well as possible limitations on who they would allow to buy stocks, based on net worth and experience. Assuming you got through that red tape, buying stocks themselves required paying transaction fees. These fees applied when you bought, as well as when you sold the security. Making matters worse, given the fact that these fees were transaction based, it often didn’t make sense to buy small quantities of the stock, not to mention the issues associated with buying “odd lots,” which is a quantity less than 100 shares.

When some of the modern brokerage firms, such as Robinhood and Cash App began offering commission-free trading, it opened the door to an entirely new group of potential investors. No longer did someone have to be concerned with paying fees which provided a disincentive to purchase a small number of shares. The concept of an odd lot disappeared and investors were free to purchase as few, or as many, shares as they like, even if such purchases were not in even numbers.

As great as commission-free trading is, there were still some barriers to the average investor just starting out.

First, stocks aren’t free. And their prices vary widely. A share of Apple stock can trade at a price that is very different than a share of Amazon or Facebook or Ford. Without enough funds to buy at least 1 share, you were traditionally prevented from being able to invest in that company. How does the new investor buy any shares at all if they don’t have enough money to invest in even a single share of a company?

Making matters more difficult, let’s assume the investor wants to add $10 or $50 to their portfolio each week. How can they do that if they are forced to buy whole shares? They would have to save up their periodic addition to their portfolio until they had enough saved to buy a whole share. This is cumbersome and inefficient. The money they are saving is not invested while it accumulates to enough to buy the share.

But there is a second, more fundamental issue that the new investor faces. Diversification can be difficult if they have limited funds. It is common knowledge that an investor needs to purchase a number of stocks to fully diversify their portfolio. While no set number of securities is agreed upon as the ideal portfolio to take advantage of the effects of diversification, conventional wisdom is that it can take as many as 30 securities to fully diversify. With the need to buy such a wide array of stocks to diversify a portfolio, even buying one share of each stock can result in the need for a sizable amount of money to start investing in individual stocks efficiently.

Fractional shares change all of this. With the advent of the fractional share, together with commission-free trading, a new investor can start a portfolio with very little funding.

WHAT ARE FRACTIONAL SHARES?

As the name implies, a fractional share of stock is just that: A fraction of 1 share. Let’s imagine that a share in a company you are interested is trading for $100 per share. A fractional share would be any portion of a single share. So 1/10th of 1 share of this stock would be worth $10. And 1/2 of 1 share of the stock would be worth $50. And so on.

You can see how this might be useful. Let’s imagine that I don’t have $100 available to invest in 1 share right now. I only have $25. That is ok. I don’t need $100. I can invest the $25 I have and buy 25% of 1 share of stock in the company.

And what about the investor that wants to add a small amount of money to their investment portfolio each week or month? Fractional shares facilitate that too. The investor doesn’t have to wait until they save up enough for a whole share. He or she can buy fractional shares of stock immediately with as little funds as they have available at the time.

This opens up a lot of doors for new investors. The possibility of buying fractional shares allows them to invest whatever funds they have available at the time, in whatever company they want. They don’t have to worry about whether a stock is too “expensive.” They simply buy a fraction of the security, and enjoy the benefits of owning stock based on that fractional ownership.

RETURNS AND FRACTIONAL SHARES

What about returns? Does owning fractional shares affect the investor’s returns? No, not in the true sense of the term “return.” An 8% return is an 8% return, whether it is on a $1,000,000 investment or a $1 investment. The return is the return. Certainly, in absolute dollar terms, an investor stands to make less money if they own less of the security. For example, if you only own 1/2 of 1 share of Apple stock, you only stand to make 1/2 of the dollar return associated with a share of that stock. This is true whether the return is based on the stock appreciating or paying dividends. But, 1/2 of a dollar return is better than nothing. And without fractional shares, your choice would be to hold a whole share of the security or nothing.

But that isn’t the only benefit of fractional shares.

DIVERSIFICATION OF FRACTIONAL SHARES

One of the key benefits of fractional shares for the new investor is one that doesn’t get enough attention, in my opinion. Diversification. Any relatively knowledgeable investor will tell you that diversification is important to investing. The idea is that, by combining stocks in a portfolio, we can reduce the risk of the portfolio, without reducing the returns at the same rate. This is an important concept when it comes to managing a portfolio of securities. In fact, diversification is so fundamental to the concept of investment portfolios, Wall Street assumes you will always diversify. After all, any rational investor would want to reduce their risk exposure, right? And since any investor would diversify their portfolio, they are not paid to carry risk they could eliminate through this diversification.

With that in mind you can start to see that this presents a huge problem for the investor who is just starting out. Returns from individual stocks do not pay investors for the risk associated with holding any specific stock by itself. The returns are only sufficient to pay for the risk inherit in holding a well-diversified portfolio. Therefore, an investor who holds only 1, 2, or even 5 stocks, is being underpaid for the risk they are taking on. Nobody likes to be underpaid.

How can an investor who has limited funds to start investing ever fully diversify?

Enter fractional shares. Since based on the concept of fractional shares an investor can buy stocks in whatever fraction they desire, they are free to invest their funds in a wide range of stocks, no matter how little money they have available.

In other words, with as little $30, I can invest in 30 different stocks. $1 per stock. And by holding 30 different stocks in my portfolio, I have fully diversified, and therefore, am being paid appropriately to take on the risk inherit in that portfolio. In other words, I can take advantage of all of the benefits of diversification, even though I only have $30 to start my investing journey.

WHERE TO BUY FRACTIONAL SHARES

There are a number of stock brokerage firms that offer fractional shares. Here is a list of some of the more common brokerages:

Cash App
Robinhood
SoFi
Fidelity
Charles Schwab