Fractional share investing can help buy pricey stocks.
Buying fractional shares can help bring pricey, big-name stocks like Google parent company Alphabet (ticker: GOOG, GOOGL) or Amazon.com (AMZN) within reach for the average investor. This investing strategy is becoming mainstream, thanks to brokerage firms that allow investors to purchase stock shares in increments. "Fractional share trading, which is the ability to buy or sell less than one share of a stock or exchange-traded fund, provides investors of all sizes access to a diversified investment portfolio," says Rob Cavallaro, chief investment officer at RobustWealth. "They say the only free lunch in finance is diversification and now all investors can have a seat at that table." Here are the seven most important rules to know when pursuing fractional investing to trade stocks or funds.
Review pricing carefully.
Since buying and selling fractional shares is a relatively new ground, there are often misconceptions surrounding how it works. "It's important to remember that when buying fractional shares, you are not buying them from the market," says Merlin Rothfeld, investment strategist and instructor at Online Trading Academy. Instead, incremental stock shares are purchased from the broker, which can trigger a few unknowns. What investors need to understand is how the broker pricing works and what share price they're paying to buy or sell stocks incrementally. The key is to avoid buying high and selling low. "This is like an added fee to your transactions," Rothfeld says. "And while it may seem insignificant, it can add up quickly."
Keep objectives in sight.
Investors should have a clear idea of what they expect incremental shares to do for them. "Fractional shares and commission-free trades have democratized investing, but they also make it easier for individuals to engage in trading rather than investing," says Brian Walsh, manager of financial planning at SoFi. He says greater access to stocks is a good thing, but it can introduce challenges to long-term investment growth. Buying and selling stock shares fractionally can yield immediate returns in the near term but the focus is on short-term price movements. "Historically, frequent trading based on short-term fluctuations reduces long-term returns," Walsh says.
Leverage the power of time.
With any investing strategy, time plays a part in determining outcomes. When the focus is on retirement, for example, the longer an individual has to take advantage of compounding interest, meaning interest earned on interest, the better. Delays can potentially be costly if it means several years or even decades of missed compounding opportunities. Cavallaro says fractional share investing can be particularly powerful for younger investors who are at the beginning of their careers and need an entry point into the stock market. "Even the smallest investors can now start saving and investing in a diversified portfolio at a young age," he says. "Digital advice platforms using fractional share trading allow investment advisors to implement sound retirement strategies."
Choose the right brokerage.
Several brokerage firms offer fractional share trading, including Stash and M1 Finance. From a liquidity perspective, an individual's choice of a brokerage firm to buy incremental stock shares is important. A key rule to follow is making sure the brokerage can help the investor divest or sell fractional shares quickly if necessary. Guy Baker, founder of Wealth Teams Alliance in Irvine, California, says the problem with fractional shares is that selling may be difficult since the brokerage has to have whole shares. This may mean delays in changing position in a particular stock. "In a falling market, if there is no liquidity for purchase, it is likely much of the investment gains can be lost," Baker says.
Set realistic expectations.
One question investors might have: Can fractional share investing make me rich? The short answer is that it's not a magic bullet for building wealth. "Fractional shares won't give your portfolio an edge – they're no better or worse than any other investment," Rothfeld says. He says the same rules apply to buying and selling stock shares in increments as they do to any other investment. That means determining the rate of return that's needed to align with investment goals, then building a portfolio that's diversified to deliver those returns. The appeal of fractional investing is that it doesn't require as much capital to get started but it's important to keep that in perspective about returns.
Pay attention to fees.
When buying and selling fractional shares, it's important to understand what commission fees the brokerage firm charges. Paying what seems like a relatively small flat fee on individual trades can translate into larger percentages which can directly impact returns, Rothfeld says. For example, assume an individual purchases $100 worth of fractional shares each month and pays a $5 fee to do so. That translates to a 5% fee, which when compared to a mutual fund or ETF that may have an annual expense ratio of 0.75% or less, seems quite steep. The good news is, more brokerage firms are jumping on the commission-free bandwagon, including Schwab, TD Ameritrade and E-Trade, so fees for fractional share investing may be easier to avoid in the future.
Don't overlook dividend reinvestment plans.
The rules mentioned so far apply when investing in fractional stock shares through a brokerage. Dividend reinvestment plans, known as DRIPs, can offer another avenue to fractional investing. With a DRIP, investors can purchase shares of stock, then reinvest any cash dividends generated by that investment into additional fractional shares. Typically, these shares are purchased and redeemed directly through the company, rather than being traded on a stock exchange. Reinvested dividends are treated as taxable income but the advantages of buying fractional shares through a DRIP plan include potentially purchasing them at a discount and being able to trade them commission free. The drawbacks are incremental shares may be that these assets are less liquid.
A few rules for investing in fractional shares are:
- Review pricing carefully.
- Keep objectives in sight.
- Leverage the power of time.
- Choose the right brokerage.
- Set realistic expectations.
- Pay attention to fees.
- Don't overlook dividend reinvestment plans.