Did you know you can start building an investment portfolio with as little as $5? That's less than the cost of a venti white chocolate mocha. The low-dollar entry point is made possible by a practice called fractional investing.
Fractional investing involves purchasing stock or ETF shares in units of less than one. If you had only $5 to spend and you wanted to own Vanguard's S&P 500 ETF, you could use your five bucks to buy about 0.017 shares. In the old days, before fractional investing was an option, you'd have to save until you had enough to buy a whole share of VOO for about $295.
Fractional investing isn't brand new, but it has recently become more widely available. Major brokerages Schwab and Fidelity both offer fractional buys. You can also find the feature in startup investing applications like Robinhood and Betterment. Financial experts see the expansion of fractional investing as a great thing for the investment community. Novice investors can jump right in and start investing today, without having to spend thousands to build a diversified portfolio.
The hidden danger of fractional investing
While fractional investing provides increased access to the stock market, there is a hidden danger. It has to do with the perception of risk. When the dollar amount invested is low, it's vastly easier to discount the risk. But overlooking risk greatly increases the chances you'll have a bad experience. And the worst outcome is not that you might lose $50 or $100 over time -- it's that you'd be turned off of investing for good.
You may be investing only $5 at a time, but it's not play money. If you're ready to kick off your fractional investing program, take the potential for risk seriously. Follow these three best practices to set yourself up for a long and fruitful investing habit.
1. Focus on the long term
Fractional investing is not a get-rich-quick scheme. You're not buying $5 slices of Amazon so you can sell them quickly for $6. You're building a portfolio of assets you can hold for decades. This is called the buy-and-hold approach, and it's the simplest way to make money with your investments.
When you buy and hold, you're capitalizing on the long-term behavior of the stock market. Since the 1920s, the S&P 500 index has produced long-term average growth of about 7% annually after inflation. That average includes all the bad years, like 2008 when the S&P 500 lost 38.5% of its value. The lesson to remember there is that the good years outwork the bad ones if you wait long enough.
Investors who trade heavily miss out on those long-term trends. They're also more likely to make timing mistakes that erode their returns.
The simplest way to diversify your fractional portfolio is by investing in exchange-traded funds, or ETFs. An S&P 500 ETF is a good choice because it gives you exposure to a broad base of large companies. The fund will mimic the behavior of the S&P 500 index, which represents about 80% of the total market value of the NYSE.
If you'd rather own individual stocks, plan on owning at least 20 separate positions. That way, if one company goes belly up, you won't lose more than 5%.
3. Learn about asset allocation
You can diversify by owning different shares of stock, but you can also diversify by owning different types of assets. Being strategic about the composition of your portfolio across asset classes -- say, stocks vs. bonds -- is the process of asset allocation. The idea is to tailor your overall risk and manage volatility by combining assets that behave differently.
Stocks, for example, tend to have high growth potential but also high risk. Bonds, on the other hand, typically hold their value and produce predictable levels of income. If you have a high tolerance for risk, you might hold 90% stocks and 10% bonds. If you have a low risk tolerance, you'd prefer a composition that's closer to 60% stocks and 40% bonds.
Become a student of the various asset types and how they behave. That will help you build a well-rounded portfolio that balances risk and growth potential appropriately.
Fractional investing still has risk
With fractional investing, you can buy quality stocks and ETFs for the price of a fancy coffee drink. That low entry point is ideal for cash-poor savers, but it doesn't mitigate the inherent risks of investing.
The good news is that you can manage the risk by holding out for long-term growth and diversifying, both within and across different asset types. Those habits will serve you well today and tomorrow, long after you've outgrown those fractional buys.