The Rise And Reality Of Fractional Investing: Why Education Is Essential
Tamara Kostova, CEO of Velexa, empowers institutional clients through customized and embedded investing services.
Fractional investing is gaining ground, with the FCA stating that it’s a “significant and growing part of the consumer investment market in the U.K.” Although the ability to buy parts of shares existed as far back as 1999, brokerage fees and lack of automated tracking made the experience both expensive and complex.
The emergence of robo-advisories and online brokerages offering zero-commission trading, such as Robinhood and Schwab, has made it easy and affordable to buy portions of shares. Previously disenfranchised investors can now buy dollar-based shares and hold blue-chip stocks for a fraction of the price. Instead of paying nearly $200 for an Apple share or $350+ for a share in Microsoft, users can buy portions of shares without any fees, thereby further democratizing the world of investment.
However, some critics believe that the benefits of fractional investing are only surface-deep, giving new investors a sense of belonging while denying them the full participation that comes with being a shareholder.
Another criticism lies in the world of fractional property ownership, similar to fractional shares, except the underlying asset is real estate instead of equity. In this model, investors reap a portion of the property’s rental income, despite a lack of real ownership and potential liquidity issues.
How Did We Get Here?
As Big Tech grew bigger, disenfranchisement grew worse as stock prices rose to impossible levels for many aspiring investors.
In June 2022, Amazon executed a stock split, its first in 23 years, dividing its stock by a staggering 20:1 ratio. Before the stock split, a single Amazon share cost well over $2,000, an astronomical cost for many retail investors. After the split, each share was worth $127.
Alphabet also split its stock in 2022—the first split since 2014. By the time of the split, Alphabet’s stock had reached $2,255.34. It, too, split by a ratio of 20:1, bringing each share’s price down to $112.64.
By the time these splits occurred, fractional shares were already well established. Robinhood has offered fractional shares since 2019. Fidelity started offering it in January 2020. And Schwab entered the fractional share market in June 2020.
The narrative around fractional shares is that they empower less affluent investors, democratizing investment so that anyone can take part. The statement is partly true in a monetary value sense—investors can buy shares (and property) for pennies and reap pro rata returns when dividends are paid out.
The Drawbacks
However, the practice has several cons that new investors should know about.
1. False Sense Of Financial Security
Fractional investment is unlikely to ever produce significant returns. As appealing as the slogan of “buying shares for as little as a penny” sounds, the return on a 100% increase for such an investment is still only an additional penny.
Returns of a few hundred dollars are significant to many people, but even these are unlikely when the initial principal is low. For example, to gain $200 on a $500 investment, a portfolio would need to grow by 40%. Considering that investors typically aim for 10% growth per annum, that $500 would typically take several years to earn $200. The investor would probably be better off earning those funds elsewhere when dealing with such small figures.
The hype that one is “investing” can provide a false sense of financial security to inexperienced investors who don’t take the time to crunch the numbers to see what these investments will truly bring them.
Although it isn’t recommended to ever hold only a single stock, new investors might consider doing just that for their $500 now that companies like Alphabet and Amazon have split their shares by so much. At least the investor would have the other rights that come with being a shareholder.
2. Vendor Lock-In
Stock exchanges don’t support fractional shares. For a broker to offer fractional shares, the broker itself must buy the entire share and then sell it in pieces to investors. Because the means to do this is based on proprietary software, the only way to move your “shares” to another broker is to sell them and then buy the fractional shares elsewhere.
3. Gamified Experience
Robinhood came under fire in 2020 for “gamifying investment,” which involved encouraging inexperienced users to invest funds when it was not always in their best interests. Robinhood eventually paid a $65 million fine to settle the case.
The “gamified experience” presents a double-edged sword: Fractional investing is aimed at people with little or no investment experience, and companies want to make it as easy as possible for these users to invest. Gamifying the experience achieves that.
However, the very lack of experience these users have means that some of them probably shouldn’t be encouraged so aggressively to invest above their risk tolerance.
4. Lack Of Voting Rights
Owning a fractional share gives the user zero voting rights in the company they’re supporting. The broker owns the shares and thus has the right to vote as a shareholder.
The lack of voting rights reduces the activity of investing into a cash-grab. Although the primary purpose of investing is indeed to make a return, the spirit of it is also to take a hand in guiding the company you’re supporting so that it becomes profitable while aligning with the values you support.
Not Only A Private-Sector Problem
Fractional investing won’t necessarily close the great divide that exists between those who can invest and those who can’t.
Although it’s a step in the right direction in the private sector, the public sector could help close that gap as well. It is important to take financial literacy seriously, thereby empowering people to better manage their finances and so have more to invest. The second thing it could do is consider enforcing stock splits when prices grow astronomical.
So, is fractional investing helping to bridge wealth gaps or exploiting the marginalized? Investors can answer that for themselves. But they should minimally be aware of what they’re getting when they buy fractional shares or property and treat these as the vehicle they really are—a dollar-based investment strategy devoid of ownership, which can return a few pennies or dollars for the extra cash you have lying around.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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