The phrase “democratizing finance” has become something of a rallying cry in investing circles.
For many investors, the more high-priced stocks – think Tesla Inc. or Berkshire Hathaway Inc. – used to be out of reach. The automaker’s shares, for example, were exchanging hands for around US$350 on Friday.
But for those who are investing smaller amounts, there’s now a way to buy in. Fractional trading allows investors to buy slices of shares, bypassing the old need to plunk down hundreds or even thousands of dollars to own a single share.
It feels liberating but, like all revolutions, it comes with a hidden cost.
A paper published last year in The Review of Financial Studies examined the impact of fractional trading and came to a provocative conclusion: while it opens the door for smaller investors to access capital markets, it also appears to transplant speculative behaviours from the domain of penny-stock dabblers into the realm of more-stable, medium-sized companies and blue-chip stocks.
Far from a purely benevolent innovation, “democratizing” access could inflate industry profits at the expense of financially less-savvy investors. That is because more people than ever are trading in tiny amounts, but collectively, they can move markets in ways even institutional players were not fully prepared for.
Before fractional trading became widespread, small-scale speculators might have turned more heavily to trading penny-stocks owing to what is known as a “nominal price illusion.” This is the idea that a lower share price in and of itself indicates a stock is cheap without regard to its fundamentals.
The study found that when fractional share trading was rolling out, speculative traders suddenly found it easy to buy a fraction of a higher share-price stock instead of rolling the dice on penny stocks. While zero-commission trading was also being introduced around the same time – which made it easier for smaller investors to participate in stock markets – the authors found that the major driver in the surge of small-volume trading in more recognized companies was owing to fractional share trading.
Why should this matter to the rest of us? It partly comes down to how market capitalization is calculated. A company’s market cap is simply the last share price multiplied by total shares outstanding. Even a run of small trades, especially in stocks with substantial retail interest, can bump that last-traded price higher.
During a meme-driven buying spree, thousands of fractional-share orders can collectively push the price up, yielding a notional spike in market cap far beyond any shift in the company’s fundamentals. This is precisely how “meme” frenzies gained traction over the past few years: crowd attention, supercharged by social media, sent stock prices soaring, and crashing.
Historically, penny stocks offered that low barrier to entry that could entice gambling-like behaviour. But now the “penny-stock mentality” may have simply waltzed onto bigger stages. We have seen times when GameStop Corp., Tesla, or AMC Entertainment Holdings Inc. soared on waves of small-ticket purchases, only for many latecomers to suffer when prices eventually tumbled.
Simply put, fractional trading has bridged the gap between modest capital and premium stocks, but it may have also imported more volatility into names that once seemed too large or stable to be the subject of daily roller coaster rides.
However, let us be fair. The silver lining is that fractional trading offers genuine opportunity. Budding investors no longer have to scrape together the full share price of an expensive stock to gain exposure to a moderately diversified stock portfolio. Not every investor wants to buy ETFs, but now anyone can own Berkshire Hathaway.
But here’s the problem: a segment of these new entrants is in it for the rush, not the fundamentals. Because of limited financial literacy, many chase stocks based on hype.
The industry, in turn, reaps profits by fuelling that activity, through payment for order flow, through greater trading volumes or through margin-lending revenue to these newly minted investors. Even zero commissions do not necessarily mean no cost.
In the end, the “democratization” that comes with fractional buying could be a Trojan horse. Making high-priced stocks more accessible is laudable, but we must recognize the surge in speculation when more small trades occur in a frenzy. If these trades are based on minimal research, the main beneficiaries may not be the novice investors.
The upshot? Fractional trading is here to stay. But if we truly want to empower the next generation of investors, we must balance the promise of inclusivity with the understanding that stronger investor protections and robust financial education must accompany broader access, or we risk fuelling speculation rather than long-term wealth-building.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.
