Fractional Shares: Bite-Sized Investments with Benefits
I am always happy to hear from young investors who, when money starts burning a hole in their pocket, are looking for ways to invest it rather than just spend it. I am quite intrigued by fractional investing, which is drawing many young investors to the market.
In this week's Q&A, I talk about why this bite-sized investing method is gaining traction. Names and personal information are excluded to protect privacy. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.
Q: What are your best recommendations for a beginner investor starting with less than $500?
A: To be a wise investor, you have to start somewhere, hopefully at a young age. A good place to start - particularly if your saving and/or spending power is limited - is fractional investing. This type of investing is growing in popularity, particularly among younger stock buyers.
What is Fractional Investing?
In fractional investing, people buy affordable "bites" of high-value or high-priced stocks for a fraction of the cost of purchasing a full share of the stock. Because some markets, like the New York Stock Exchange, require investors to buy whole shares of securities, brokerage firms purchase the full shares up front and then sell partial shares to investors, allowing them to purchase quality stocks at lower prices.
Fractional shares themselves are not new. They have long resulted from stock splits and other corporate actions and from DRIPS, or reinvestment plans. And, of course, mutual funds have long dealt in fractional shares.
Fairly recently, brokerage firms started selling fractional shares online, including Acorn, Betterment, M-1 Finance, Public, Schwab, Robinhood, Stash, Folio Investing, Montif, Stockpile, etc. They all have their good and bad points - the key is finding the one that best fits your young investor’s needs.
Fractional = Affordable
Buying fractional shares helps build a diversified portfolio that was previously unaffordable for many. For example, if a stock trades for $500 per share, you’d need at least $500 to buy a single share. If you wanted to buy more than one share of that stock, you’d have to purchase in increments of $500 ($1,000 for two shares, $1,500 for three shares, etc.). Not so with fractional shares. This type of buying allows a “cash-limited” investor to buy the amount of stock she or he can afford, whether it’s $5, $50, or $500.
As most tech-savvy youngsters know, today’s most popular stocks are also some of the most costly to buy. Building that necessary diversified portfolio consisting of a few shares of each would require… gasp… thousands of dollars in upfront money. Using the fractional shares approach, you can allocate a relatively small portion of your cash to each company whose shares you want to buy. If that’s 10%, you could invest $50 in 10… yep… 10 different companies, regardless of their share price.
Fractional = Diversified
Buying fractional shares allows you to build a more diversified portfolio than if you invest all of your money in a single company.
To explain further, let’s review some investing fundamentals. There are three general asset classes within a typical investment portfolio:
Stocks (also called equities) which represent tiny bits of ownership in companies and which offers the highest – but likely more volatile – yields.
Bonds (or fixed income) which pay interest to investors who lend money to a company or a government. Bonds generally have an inverse relationship with stocks – often, when stock prices increase, bond prices decrease.
Cash (or cash equivalents) is the money in your savings account or pocket. Cash provides the least risk and, accordingly, the lowest return. In fact, it often loses value due to Izzy the Inflation Monster. And there are other asset classes, including real estate (property), commodities (natural resources, precious metals), etc., that can provide additional diversification.
It's important to build a diversified portfolio through asset allocation, which is achieved by spreading your investment dollars across a broad range of assets to reduce investment risk. In other words, it's important to invest your money in a mix of the above asset classes (stocks, bond, cash).
Although I’m a proponent of mutual fund investing for young investors because of its built-in diversification, I think there are more effective avenues to learn the fundamentals of saving and investing for youngsters with little or no investment skills and little money - such as fractional investing.
In Sum
The primary reason fractional investing is so beneficial for those with limited cash is diversification. Diversification is the simplest way to boost an investor’s return and reduce risk. And by pursuing a fractional shares approach, a diversified portfolio can actually be simple to achieve for new investors with limited resources.
Of course, it all begins with saving, so start hoarding a small percentage of that allowance and those birthday and Christmas gifts… and do some research on the purchase of fractional shares.
For more information on brokerages that sell fractional shares, read this.