What Are Fractional Shares and How Do They Work?

With the price so high for some stocks, how can the average person ever hope to invest? Enter fractional shares: Instead of purchasing a stock at its full price, it’s possible to purchase a fraction of one share of a stock.

This raises the questions: How do fractional shares work, how can you buy partial shares of a stock, and are fractional shares worth it?

What Is a Fractional Share?

Fractional shares of a stock are also known as fractional equity shares or partial shares of a stock. Typically, investors can buy fractional shares based on a dollar amount, rather than the current trading price of one share.

Example of a Fractional Share

Let’s say Stock A is trading at $250 per share. You like this company and want to buy their stock, but you only have $50. With fractional share investing, it’s possible to buy $50 or ⅕ of Stock A.

Fractional Shares vs Whole Shares

While fractional shares are similar to whole shares, they don’t trade on the open market as a standalone product. Rather, fractional shares must be sold through a major brokerage.

How Do Fractional Shares Work?

In brief, investors can buy fractional shares of a stock through a brokerage account, and reap the same returns and dividends, proportional to the amount of stock they own.

To buy fractional shares, it helps to understand how and why they exist. Sometimes a fractional share is the result of a stock split, company merger or acquisition, or dividend reinvestment plan (called a DRIP).

Stock Split

In order to lower its price per share, a company may initiate what is called a “stock split.” A stock split may not always result in an even number of shares.

For example, in a 3-for-2 stock split, a company provides a third share for every two owned by an investor. If the investor initially holds 125 shares, they will own 187.5 shares after the stock split.

The investor still owns the same amount of stock in dollars, because the value of those shares will simultaneously drop by one-third. Sometimes, the company will just transfer cash to you in exchange for any fractional shares remaining.

Company Merger & Acquisition

A company merger or acquisition may also result in the creation of fractional shares. When one company acquires another, they may offer their shareholders the option for a stock merger (as opposed to cash merger).

With a stock merger, investors will receive a “conversion ratio,” which is the ratio that converts the shares of the company being acquired. This can result in fractional shares.

Dividend Reinvestment Plans (DRIPs)

Some, though not all, stocks pay dividends to investors. These dividends, which can be paid monthly, quarterly or annually, represent a percentage of the company’s profits that are then paid out to shareholders.

If you purchase shares of dividend-paying stocks fractionally, then you can receive dividend payouts from those stocks just the same as you would if you purchased full shares. The dividend payout you receive would be proportionate to your ownership stake in the stock. So, say you own a half a share of a stock that pays out a $4 dividend per share to its investors. You’d be able to collect half of that dividend payment or $2.

Dividend Reinvestment Plans or DRIPs can also produce fractional shares. Companies can offer DRIPs to investors as a way to reinvest in that company’s dividend-paying stock. When a stock pays out a cash dividend to its shareholders, the DRIP reinvests the money back into the stock automatically, even if the amount of the dividend isn’t enough to purchase an entire share.

DRIPs are a popular option because they don’t often have trading commissions or other brokerage fees.

Cash in Lieu of Fractional Shares

It’s possible that you may be offered cash in place of (in lieu of) fractional shares in certain situations. Instead of crediting you with additional fractional shares, the company you’ve invested with would sell those shares. They’d then send you a check representing the amount of cash resulting from the sale.

A cash-in-lieu situation can happen when a company undergoes a major transition, such as a merger or acquisition. They can also occur when there’s a stock split. It can be easier for companies to simply sell fractional shares and pay investors cash for them, versus creating new fractional shares.

If you receive cash in lieu of fractional shares, you should also receive a Form 1099-B from the company showing how much was paid to you. You’d need to include this form when filing your taxes since the IRS requires investors to account for these payments.

Can You Buy Half a Stock?

The simple answer is yes, you can buy half a stock if you’re using fractional shares to invest. With fractional shares, it’s possible to buy stock without having to purchase the entire share. Instead, you use whatever dollar amount you have available to build a portfolio.

For example, a beginning investor might have $500 to purchase shares of stock. But the stock they want to buy is trading at $1,000 per share, putting it out of reach. Thanks to fractional shares, they could still invest the $500 by purchasing 0.5 of a single share.

Then, once they have another $500 to invest, they could purchase another half share, which would allow them to own one full share altogether. Or they could use that money to buy another type of stock. There’s no rule requiring you to own full shares.

Fractional shares allow investors to purchase stocks in increments that fit their financial situation. So for instance, it’s possible to buy half of a stock but you could also use fractional investing to purchase one-quarter or one-third of a stock. This type of strategy is also known as dollar-based investing, since it’s based on the amount of money someone has to invest, rather than an investment’s purchase price.

? Recommended: Are Fractional Shares Worth Buying?

Advantages of Buying Fractional Shares

Investing money this way can offer some benefits, but are fractional shares worth it? They can be, if they help to further your overall investment strategy and goals.

Removing Barriers

The primary advantage of buying a fractional share is that investors are able to buy part of a stock that may otherwise be too expensive. In this way, fractional shares dismantle a large barrier to entry for those who want to invest.

Fractional share investing can also give young or new investors access to stock markets so that they can learn about them and investing firsthand.

For some, this hands-on approach to learning may be a more effective form of education than thinking about investment ideas or concepts in theory.

Increased Control

With fractional share investing the investor controls precisely how much money they want to spend on a stock. Fractional shares allow an investor to build their portfolio even if they don’t have a significant amount to invest.

This could allow investors to participate in the stock market for a longer period of time, without having to time the market.

Additionally, it can help investors buy the stocks that they actually want to hold in their portfolios, not just the ones that they can afford.

Increased Diversification

Because an investor can buy a variety of stocks using the money they have available, it may be easier to help in building a more diversified portfolio. Diversification, the idea that investors can mitigate some risk in their portfolios, is generally achieved by buying a variety of investments.

With more control over how much of each stock they can buy, investors could potentially construct a portfolio that is diversified to their liking.

Disadvantages of Buying Fractional Shares

Here are some of the potential downsides and risks from trading fractional shares.

Hard to Find

While investors can buy fractional shares, unfortunately traditional brokerage firms might not offer them for sale. Some brokerages may also place restrictions on selling fractional shares, since they have to be joined with other fractional shares to create a whole share in order to be sold.

Brokerage Fees

Then, those same institutions may charge a flat transaction fee to buy or sell a stock, no matter how few shares the investor plans to trade. Whether buying whole or fractional shares, trading fees and account fees can have an erosive effect on an investor’s returns.

That means that an investor would pay the trading commission whether they were buying a quarter of one share or 500 shares of a stock.

A fee of a few dollars to purchase a whole or fractional share may not seem like a lot, but it can be to an investor without much capital to get started. This is especially true if the investor is interested in building out a diversified portfolio, since buying fractional shares of 10 stocks could mean paying the fee 10 times.

How Different Institutions May Handle Fractional Shares

Each brokerage firm has a different strategy for handling partial shares, so it’s important to pay attention to the terms. For example, if you’re transferring your assets from one firm to another, and the new brokerage doesn’t accept fractional shares, you might have to sell your fractional shares — and incur certain expenses or capital gains taxes.

While some brokerage firms don’t allow the purchase of fractional shares, they may still end up in customer accounts for the following reasons:

•   Sometimes, brokerage firms have policies in place to pay out cash when a customer acquires a fractional share through a stock split.

•   Other brokerage firms may charge a higher transaction fee to sell partial shares received from dividend reinvestment, and may only allow shareholders to sell partial shares if they sell all their shares of that particular stock.

Pros and Cons of Fractional Shares

Where to Buy Fractional Shares

If you’re interested in purchasing fractional shares, you have a few options for doing so, starting with DRIPs. The problem, however, is that while some companies may offer DRIPs to new investors, it’s more common for this purchase option to be offered to existing shareholders only. If a company does offer a DRIP to new investors, the purchase typically has to be done through a third-party administrator.

Another option is to buy fractional shares using a mutual fund. Though a mutual fund is not a stock, it is a fund that holds many stocks. Some mutual funds effectively allow for the purchase of fractional shares, because some brokerage firms allow investors to purchase mutual funds using dollar amounts.

So, even if a mutual fund is trading for $79 per share, you could buy $1,000 worth of that fund, and effectively own 12 full shares plus 0.65 of that fund.

An investor could get started buying a fractional share of a mutual fund, and achieving diversification through owning the many stocks that are held in one fund.

Are ETF Fractional Shares Available for Purchase?

Yes, some brokers do offer fractional shares of exchange-traded funds, or ETFs. Given that ETFs are a low-cost way to buy into different market sectors, owning fractional ETF shares could offer another way to add diversification to your portfolio.

Returns From Fractional Shares

It’s worth repeating: The returns from fractional shares — whether gains or losses — are proportional to the fraction you own. If you own 0.33 of a stock, you would see a third of the gains (or a third of the losses), and a third the dividends, if it’s a dividend-paying stock.

You don’t have to wait until you own a full share to “qualify” for those stock returns. You see the same gains or losses as soon as you buy the fractional share.