By definition, a fraction means something less than a complete unit. The same applies to shares too. Fractional shares arise out of multiple corporate events, allowing small investors to invest with less capital and gain benefits. But have you ever wondered how fractional shares work and how the stock market deals with them?
This article talks about the meaning and concept of fractional shares, how they work and their advantages and disadvantages.
What Is A Fractional Share?
Fractional shares are typically fractions or parts or pieces of whole shares. Fractional investing aims to make some high-priced stocks affordable and accessible to investors. Exchange-traded funds (ETFs) are also available to be bought as fractional shares.
Understanding A Fractional Share
Here are some ways by which fractional shares are created.
Stock split or reverse stock split
In a stock split, the company splits one share of existing shareholders into multiple shares to increase the number of total outstanding shares and reduce the individual share price.
For instance, if the company goes for a 2:5 stock split, you will receive five shares for every two shares you own. If you own 11 shares, you will have 27 1/2 shares after the stock split, and that additional half share will be a fractional share.
In a reverse stock split, the company merges multiple shares of investors into one share to reduce the number of total outstanding shares and increase the individual share price.
For instance, in a 5:2 reverse stock split, each of your five shares will convert to two shares. So, if you own 11 shares, you will have 4 2/5 shares following the reverse stock split, and that extra portion will be a fractional share.
Dividend reinvestment plans
A dividend reinvestment plan automatically enables investors to buy additional company shares from cash dividends. In this program, you may end up with fractional stock. For instance, you have 100 shares of a company which pays dividends of $0.20 per share. As a result, you are likely to receive $20 as dividends which would be used to buy company shares. If the stock is traded at $50, you will have 2 1/2 shares from the dividends, and that extra half a share will be a fractional share.
Mergers and acquisitions
The shares of a company may be exchanged for new shares, typically using a ratio, when it merges or gets acquired. For instance, two shares of XYZ Limited may become one share of ABC Limited if the latter company acquires XYZ Limited. Such corporate actions may result in fractional shares.
How Do Fractional Shares Work?
Fractional shares work similarly to whole shares. Let’s understand how fractional shares work with an example. For instance, XYZ stock is trading at $200 per share. You decide to invest $20, which will buy you 1/10th share of the stock. Now, if XYZ stock declares a dividend of $2 per share, you would receive $0.2.
If the stock price inflates by 5% and reaches $210, your holding will grow to $21 from $20. If the stock price decreases by 5% and reaches $190, your holding will fall to $19 from $20.
Advantages Of Fractional Shares
Limited capital
Many popular stocks trade at such a high price, making it unaffordable for many investors to buy them. You may need to wait a long time to afford even one share. However, fractional investing may solve that problem.
For instance, if your favourite stock is trading at $2,000, you may buy a fraction of its share at a lower cost and start getting the benefits of compounding returns instead of dreaming or waiting to buy it for years.
Diversification
Investing all or most of your investable income in fewer stocks may be risky, as you would lose greatly if those stocks fall. However, diversifying your investments helps you spread risks among more stocks which may reduce the likelihood of losing most of the money even in adverse conditions. Fractional shares help you diversify your investments.
Suppose you have $1,000 for investing. Instead of investing all your money into one or two popular stocks, you may choose to invest $100 in 10 companies by buying fractional shares of their stocks.
Flexibility
You may need to allocate a particular amount if you want to buy whole shares. However, fractional shares allow you to decide the amount, and the shares will be allotted to you based on that amount.
Disadvantages Of Fractional Shares
Limited options
All the companies listed on the stock exchange offer whole shares. However, not all brokerages offer fractional shares, and not all stocks are open for fractional investing.
Indian stocks do not allow fractional share investing (As of November 2022).
Lower liquidity
Compared to whole shares, fractional shares may trade less frequently, and it may take longer to fulfil your buy order as brokers wait to have enough fractional orders to buy whole shares. Plus, it could take longer to sell your fractional shares as some of them may see little demand.
Additional difficulties
Transferring fractional shares to other brokers may not be permitted by some brokers. Plus, trading in these shares might lead to tax assessment-related complications.
Final Thoughts
The concept of fractional share investing is relatively new, and it is important to thoroughly understand its pros and cons before getting into it. It is also important to understand brokerage policies and additional charges if any.
If you want to invest in combinations of equities and ETFs, take into account WealthBaskets from WealthDesk. They are created by SEBI-registered professionals and are research-backed combinations based on an idea, theme or strategy.
FAQs
Fractional shares may be a good option for investors wanting to invest in high-priced stocks with limited capital. Though, there are a few challenges to investing in such shares, like tax assessment complications, lower liquidity, etc.
Fractional shares may enable you to have diversified asset allocation with the capital you have. However, fractional investing would give you a fractional benefit. For instance, if the fractional stock pays dividends, you would only get a portion of the dividend.
Fundamentally sound fractional shares may help you create wealth in the long run. However, not all fractional shares perform well and help create wealth.
Some stocks do pay dividends. Investors with fractional shares of stock that pay dividends will receive dividends according to the portion of shares they own.
You would have to pay capital gain tax while selling fractional shares.
