It used to be that novices went about investing the right way. They bought low-cost mutual or exchange-traded funds using the dollar-cost averaging strategy and held them for years.
But a gigantic stock market rally since late March seems to have inspired millions of new investors. And instead of being confined to relatively safe, stodgy funds, they now have the ability to buy so-called fractional shares, or less than one share of stock. This is giving more people access to the stock market than ever before. I would not characterize this as progress.
Back in the days of pin-striped suits, suspenders and bull and bear cufflinks, one used to have to buy a “round lot” of 100 shares to invest in the stock market. The cost to do so could easily run into the the thousands of dollars. Sure, “odd lots” of less than 100 shares were permitted, but they were frowned upon because such trades were more expensive for brokers to executive and not worth the effort. This did a pretty good job of keeping uninformed investors out of the market and from hurting themselves financially.
Now, the business of executing trades has become more efficient and less costly, with many platforms now offering such services. This has led to something called the democratization movement, which believes that everyone should have the ability to trade stocks even if they don’t have enough money to buy even one share, let alone 100 shares. Firms ranging from Charles Schwab Corp. to Robinhood Financial LLC and Social Finance Inc. now allow investors to buy a fraction of a share for as little as $5 or less. Stash Investments LLC even has a “stock back” debit card that offers share rewards on purchases, according to Bloomberg News. The Wall Street Journal recently reported that Fidelity Investments, which rolled out fractional trading to customers in January and February, says more than 340,000 of its accounts have placed a fractional trade.
Someone who has only $5 to invest should not be putting that money into stocks; they should be buying food. Nobody is saving for retirement $5 at a time. This is rank speculation, and most of it is on the high-flying tech companies that have mostly refused to split their stocks.(2) Only three members of the S&P 500 Index have split their stocks this year, and more than 30% have gone without doing so since 2000 or longer, according to Bloomberg News.(1)
I doubt there is much in the way of profit for discount brokers in trading fractional shares, but what they are really hoping for is that all these small accounts will one day turn into large accounts. In that sense, fractional shares are a gimmick, designed to ensnare small, unsophisticated investors into becoming paying clients. Commission-free trading was a gimmick, too, as commissions have only really represented a small part of overall revenue in recent years.
Stunts like these would be difficult to pull off in a bear market. But the brokerages have been successful in appealing to people’s greed, along with Instagram accounts featuring pictures of infinity pools and Lamborghinis supposedly bought with the proceeds of day trading. Numerous studies on the performance of small investors, including one from Brad Barber and Terrance Odean of University of California at Berkeley, show that they tend to underperform the market by holding “under-diversified portfolios” and “trading actively, speculatively, and to their detriment,” and that “individual investors earn poor returns even before costs.”
Most ordinary people are psychologically hard-wired to behave in suboptimal ways when it comes to investing, and fractional shares are just another way for discount brokerages to facilitate this behavior. Even Vanguard, one the few firms that does not appeal to investors’ sense of greed, acknowledges that many investors actively trade their mutual fund offerings, leading to diminished performance.
History shows that the vast majority of these new traders chasing hot stocks will lose money and probably end up worse off than if they had never invested in stocks. Democratization of the stock market will fail, leading to a generation of investors distrusting Wall Street and perhaps even capitalism. Investors are most successful when they hire qualified financial advisors and pay sales charges on mutual funds and high commissions, which encourage them to buy investments and hold them for long periods of time. We have to let go of the idea that everyone should own and trade stocks because people are emotionally unfit to do so.
(1) Apple Inc. said July 30 it would split its shares 4-for-1as the stock price surged toward $400, and Tesla Inc. announced a 5-for-1 stock split on Aug. 11 as it's shares reached around $1,400.
(2) The disappearance of stock splits is one of the sadder stories of modern finance. In the past, the idea was that a company would want its stock price to be more accessible to a broader range of investors. These days, there’s the misguided notion that the higher a stock price, the more successful the company. And yet, there is evidence that liquidity deteriorates at high stock prices, which benefits neither the company nor its shareholders.
Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of 'Street Freak' and 'All the Evil of This World.' He may have a stake in the areas he writes about.
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