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4 Reasons to Use Fractional Shares Instead of Penny Stocks

By Sam Swenson, CFA, CPA – Jul 10, 2020 at 7:30AM

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You no longer need to buy whole shares to invest in great companies.

The dream of winning at penny stock investing has long been part of market folklore, popularly depicted through a Sopranos-style "Webistics" scheme or a strip mall boiler room operation. The desire to own shares of very inexpensive stocks to see their value double overnight is much akin to the thought of buying a winning PowerBall ticket -- and is also riddled with emotional distortions that strand the buyer far from true investing.

Penny stock investing can seem like a reasonable way to own a significant number of shares of a particular company, given that stocks like Amazon now trade at $3,000. However, there are a number of ways to gain exposure to reputable companies, even if you can't afford whole shares. Fractional shares should be preferred to penny stocks, particularly from a risk mitigation standpoint. 

Pennies with numbers and an upward sloping line

Image source: Getty Images.

1. Penny stocks are fraught with risks

Penny stocks, or securities priced at less than $5, may seem like a quick way to accumulate ownership and watch your investment multiply. However, there are many issues with the entire proposition. First, many of these companies have illiquid trading and wide bid/ask spreads -- in English, this means that finding a buyer for your appreciated shares may be time consuming at best and impossible at worst.

Next, some penny stocks are unknown entities with absent financial histories. In classic 1980s "pump-and-dump" schemes , controlling firms would encourage the purchase of a little-known stock, coerce unsuspecting investors to buy shares, and then unload the stock en masse once its price hit a certain level, leaving average investors with substantial losses. That's certainly not to say there aren't penny stock companies with legitimate business operations, but it's important to know that big risks can exist in this space. 

2. ETFs are accessible and easy to use

When you purchase one share of a S&P 500 ETF, or Exchange Traded Fund, you're really purchasing a tiny fraction of 500 individual companies. ETFs tend to be frequently traded, or highly liquid, meaning it is easy to trade in and out at a moment's notice. Rather than investing $200 to buy 200+ inexpensive shares of a penny stock, the same $200 can help gain exposure to several hundred great companies on a fractional level.

While ETF prices generally do not fluctuate at the same rate as penny stocks, they do allow exposure to the world's most visible companies without having to buy company stock directly. Additionally, ETFs fees are inexpensive, reduce the manual work of placing 500 trades, and provide natural diversification that will inherently benefit any investor. 

3. The dollar-based investing revolution

The idea that people want access to the best companies at any price level has led financial firms to develop new technologies that allow for direct stock investing without needing to purchase whole share amounts. Fidelity's "Stocks-by-the-Slice" feature allows investors to invest in companies on a fractional basis, which encourages investors with low levels of investable income to gain experience and prevents them from being "priced out" of certain stock investments.

Ideas like this represent a further democratization of investing -- in previous years, if you didn't have thousands of dollars to invest, you simply weren't owning Berkshire Hathaway directly. Or Google. Or Amazon. The list goes on, but the ability to invest directly, regardless of share price, is a convenient benefit that allows investors to build assets in a gradual way.

4. Focus on long-term investing, not gambling

There is a reason we don't see the world's best investors sitting at electronic slot machines on a daily basis. Transparency around investing has grown tremendously over the past two decades, and it's suggested both empirically and in satire that penny stock investments are much less attractive than investments in established businesses.

Technology now allows any lay investor to access any company in any dollar amount, rendering the number of shares purchased irrelevant with regard to long-term investing goals. It's important to remember that the goal of investing is to ensure each dollar is doing its best work for you -- this is much more likely when you're investing in the world's best companies. Like most vices, some investment gambling is fine, but the key is to know when you're doing it and to keep it to a minimum. 

The benefits of owning fractional shares significantly outweigh those of owning penny stocks, and the ultimate winners of the investing game will be those who adhere to the time-tested principles of long-term financial planning. Unless you know you're gambling -- and want to be -- penny stocks are best left out of your portfolio. 

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Stocks Mentioned

Berkshire Hathaway (A shares) Stock Quote
Berkshire Hathaway (A shares)
BRK.A
$478,675.55 (0.35%) $1,655.56
Alphabet (A shares) Stock Quote
Alphabet (A shares)
GOOGL
$97.46 (-1.02%) $-1.00
Amazon Stock Quote
Amazon
AMZN
$93.41 (-0.77%) $0.72
iShares S&P 500 Index Stock Quote
iShares S&P 500 Index
IVV
$404.09 (-0.01%) $0.03

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