Fractional Shares: Understanding the Smaller Portion of Investments

19 Dec 2020  Read 1043 Views

Ever wanted to invest in a blue-chip stock but found yourself short of money? Are you sceptical of investing the entirety of your capital into the stock of just one company? Do these doubts limit your investing capability? 

What if there was a way by which you can invest in the blue-chip stocks without having to pay the entire share price? Sounds interesting? 

Let's introduce you to the concept of fractional shares.

What are fractional shares?

Fractional shares are precisely what the name suggests. They are portions of an entire share/stock and ETF. Fractional shares are units of a stock that is less than one full share. Let us try to understand this concept through an example.

Suppose you're interested in the stock of a company that costs Rs. 1,000, but you just have Rs. 200 to invest. So, you can buy one-fifth of the share of the stock (so long as your broker offers fractional shares). 

Earlier, brokers only allowed the purchasing of full shares. But with changing times, investors are now being allowed to buy fractional shares. The result? 

Customers can specify how much money they wish to invest instead of determining how many shares they want to purchase and buy a smaller portion of a full share with limited cash in hand.

Who can purchase fractional shares?

The following types of investors can purchase fractional or sliced shares:

Investors with limited funds:

Suppose the stock of a company sells for USD 1,000. Investing in a single share of such a company would leave a hole of USD 1,000 in the investor's pocket. If he wishes to buy more, more capital would be required. 

But the concept of fractional shares allows the investors to purchase the shares within the limits of their finances, starting with as minimum as USD 1. This is why fractional share investing is also referred to as dollar-based investing

Investors seeking portfolio diversification:

Before fractional shares gained popularity, investors were forced to buy full shares. If the investors wanted to invest in shares of other companies, they would need more capital. But with fractional shares, investors can purchase portions of shares of different companies with available cash. This helps investors in creating a diversified portfolio with little money.

How does the fractional shares system work?

Holders of fractional shares are treated the same way as a holder of a full share. Fractional shareholders receive the dividend on a pro-rata basis of their holding and incur the risks and losses in the proportion of their holding. Fractional shares can be sold just as any ordinary full share is sold.

How are fractional shares created?

Fractional shares are created due to major corporate activities like mergers and acquisitions, stock splits, or dividend reinvestment plans (DRIPs). Apart from these methods, many brokerage firms have also started allowing investors to purchase fractional shares. Let us take a closer look at some of these methods of creating fractional shares:

Mergers and Acquisitions

Whenever two companies merge their businesses, or one company is acquired by another, the shares of the old company are exchanged for shares of the new company. This exchange is usually done by using an exchange ratio. 

For example, when Company A acquires Company B, it issues 3 shares for every 5 shares held in Company B. This results in the creation of fractional shares.

Stock-Splits

Stock splits refer to the process by which a company splits its stock to increase its share count by issuing additional shares to its shareholders. Say, for example, a company announces a 3:2 stock split. This means that it will issue 3 shares to the shareholders holding 2 shares. So if a shareholder held 15 shares, he would now hold (15 x 3/2) 22.5 shares after the stock split. This extra half share (0.5) is the fractional share. 

Fractional shares are also created in the process of the reverse stock split. Suppose, a company announces a 3:2 reverse stock split; the shareholders will end up with two shares for every three shares held by them.

Dividend Reinvestment Plans (DRIP)

The concept of DRIP is that the dividend earned by shareholders will be used to purchase additional shares of the company. This also results in fractional holdings. 

Suppose an investor owns 200 shares. The company declares a dividend of Rs. 0.30 per share. This means that the investor gets a total dividend of Rs. 60 for the 200 shares he owns. This dividend of Rs. 60 is used to purchase new shares of the company. Now if a share of the company is being sold for Rs. 40, the investor will be able to buy a share and a half (1.5 shares) with the dividend of Rs. 60. 

                                                  

Why invest in fractional shares?

Fractional shares offer a wide range of benefits which include the following:

Fractional shares open avenues to a wider pool of investments

Earlier, investors with limited money were limited to buying only penny stocks. But with the concept of fractional shares gaining popularity, investors can now purchase shares of a wide category of companies. Fractional shares have facilitated the shift of decision making from the number of shares to be bought, to investing on the basis of available cash.

Fractional shares enable portfolio diversification at lower costs

Investors can use their limited cash supply to buy stocks of different companies in varied businesses and industries. Fractional shares enable smaller investors to create a diversified portfolio with limited resources.

Fractional shares enable investment flexibility

Investors are bothered to set aside money to purchase a full share in one go. With fractional shares, investors are allowed to buy infractions as and when their liquidity permits.

Fractional shares are especially feasible for new investors

Since fractional shares don't require investing a substantial amount, the risks are relatively low. New investors can benefit and invest in fractional shares to maximize their portfolio returns.

Are there any risks associated with fractional shares?

Fractional shares are also prone to risks, and limitations like any other form of investment is. Below we look at some of its limitations:

Fractional shares cause share prices to inflate

Fractional shares allow retail investors to buy shares in portions or slices, which cause the price of already expensive stocks to inflate. It is a poor investment decision to invest in stocks of companies with inflated share prices.

Diversification risks

Fractional shares facilitate low-cost portfolio diversification. However, if the investors focus on low costs and make uninformed fractional purchases, they could get exposed to investment risks and suffer losses. Buying partial shares in individual companies is riskier than mutual funds or index funds.

Fractional shares are difficult to trade

Sometimes, the time taken to process the trade on fractional shares is much higher than that of the ordinary full shares. Complications arise in assessing the tax implications of fractional investments.

Final thoughts

Fractional share investments offer an array of benefits. But that does not mean it is free from any limitations. If you intend to invest in fractional shares, make sure to understand the pros and cons of such an investment. 

And if you are confident about your research and knowledge, then what are you waiting for? Contact your broker / check your trading platform to check if they provide fractional share investment opportunities!

About the Author: Shrey Salwan | 43 Post(s)

Shrey Salwan is an MBA student at FLAME University, Pune, majoring in Marketing. He is also pursuing CA and CS. He is a creative thinker, a grammar nazi, and social media enthusiast seeking to work in the dynamic world of social media and content marketing to transform technical and digital information and processes into influential stories. He has a knack for telling stories and does so through his quirky way of writing.

 

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