There's a new kid on the investing block that's making headlines. It's the practice of buying fractional shares of stock to build high-quality, diversified portfolios with a lower upfront cost.

A fractional share is a partial share of stock -- for example, one-half or one-third of a share. Fractional shares themselves aren't new. They occasionally turn up in investment portfolios, due to stock splits, mergers, or dividend reinvestment programs. You might own 19 shares of a stock that splits 3-for-2, for example. After the split, you'll have 28.5 shares. That one-half of a share functions like a smaller version of a whole share; it's worth 50% less and earns half the dividends, too.

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Fractional investing 101

What is fairly new is the ability to buy fractional shares intentionally. This capability started popping up in smaller investing start-ups like Robinhood only in the last couple years, under the names fractional investing or dollar-based investing.

The term "dollar-based" describes how fractional investing differs from traditional stock buying. Instead of specifying how many shares you want to buy in whole units, you state how many dollars you want to spend. The minimum investment is usually $5. That dollar amount is divided by the share price to calculate how many shares you'll get in the transaction. For example, you could invest $5 in Walmart (WMT -0.14%). If Walmart's current price per share is $125, your $5 investment would get you .04 shares.

Taking fractional shares to the masses

Fractional investing is in the news today because big brokerages are moving it from the start-up space into the mainstream. Charles Schwab (SCHW -2.88%), one of the largest brokerage firms in  the country, will roll out fractional investing to its customers in June of 2020. This follows Fidelity's launch of fractional investing in January, 2020.

Why fractional investing is great for early investors

Charles Schwab and Fidelity are putting their muscle behind fractional investing, because it delivers four significant advantages to early investors.

  1. Access to more investment choices: On May 18, 2020, the share price of Amazon (AMZN 0.35%) closed at a steep $2,426.26. If you've just set up your budget to support a $100 monthly contribution to your investment account, it would take more than two years to save enough for a single share of Amazon. And that's assuming the share price doesn't change. Even if you had just enough cash for one share today, you wouldn't want to sink all of it into a single stock share. The lack of diversification would be too risky.

    With fractional investing, you don't have to save up enough to buy a whole share. You have access to positions in Amazon, Alphabet (GOOGL -0.18%) (GOOG -0.16%), Apple (AAPL -0.89%), and other high-priced stocks that would normally be out of your price range.
  2. Affordable buy-in: Along the same lines, you can start investing with very small dollar amounts. You could choose to spend $10 on Amazon, for example, and that would get you roughly .004 shares at the May 18 closing price.

    Depending on the platform, you can buy as little as .001 shares at a time.
  3. Easy diversification: In the old days, diversification required buying 20 or more separate positions, or alternatively leaning on mutual funds. As an early investor, you mostly had to go with mutual funds -- because individual shares were too expensive. That problem disappears with fractional investing. You could build a diversified portfolio for $30 or $40, less than what you might pay for a single mutual fund share.
  4. Dividend reinvestment: In a small portfolio, your cash dividends might be less than $100 monthly. As a fractional investor, you can immediately put those dividends to work, rather than waiting until they accumulate to a larger amount. The earlier you get your cash invested, the more you can earn on those investments.

Investing on your terms

As an experienced investor, you can lean on dollar-based investing to deploy your cash to the market faster. As a would-be investor, fractional investing can get you in the market, building wealth, with as little as $5 -- an amount you might spend on a latte without a second thought.