BREAKING DOWN THE WALL [research]

Zhi Da’s research shows how fractional trading democratizes stock buying for retail investors.

For two weeks in January 2021, thousands of retail investors, including newbies who had never bought a single stock before, were glued to their screens watching the price of a video gaming company rise.

Some of these investors plunked down a mere $250 into a brokerage account, buying fractional shares of GameStop, a retailer that sold video and online games and still kept a brick-and-mortar presence in shopping malls.

The rollercoaster ride that GameStop’s shares would continue to take was unprecedented. It attracted the attention of Wall Street and retail investors, regulators and academics, such as Zhi Da, a finance professor at the University of Notre Dame’s Mendoza College of Business who studied the phenomenon. Da and two other professors discovered that the launch of fractional trading was a large contributor to the share price volatility.

GameStop Phenomenon

Hunkered down at home to avoid being infected with COVID-19, some prospective retail investors learned about GameStop, a company that had largely been forgotten about by Wall Street. These investors, many of whom had never opened an investment account to buy and sell stocks, soon learned about the company via Reddit, a social media company that operates much like a bulletin board where messages on all topics can be posted and discussed via chat rooms. Twitter (now called X), known as the town square, was another platform where investors discussed the stock.

The frenzy increased when these retail investors learned that stock analysis firm Citron Research, which predicted the price would fall, had downgraded GameStop’s stock in January 2021. The opposite happened, and by January 27, shares of GameStop rose by a whopping 1,500% during those two weeks, as investors poured their hard-earned money into the “meme” stock, which is a stock that gains popularity among retail investors through social media.

One major factor fueled the mania: The environment to buy and sell stocks had changed in 2019 when a handful of brokerages allowed retail investors to buy a portion of a share of a company’s stock, which is known as fractional trading.

Instead of having to save $1,668 to buy only one share of Amazon in 2019, investors now could invest in the market with just $200 and buy a very small percentage of a stock with the push of a few buttons on their smartphone app — especially tech stocks which were often more expensive.

The opportunity to buy a small percentage of the stock of Amazon or Google encouraged retail investors to transfer their money into brokerage apps such as Robinhood or Interactive Brokers, since fractional trading broke down the barrier to these high-priced stocks.

Even though these investors made smaller trades, they could also “fuel meme stock-like trading frenzies and bubbles in high-priced stocks,” wrote Da in his research paper, “Fractional Trading,” published in the Review of Financial Studies. The study was co-authored by Vivian Fang of Indiana University and Wenwei Lin of the Chinese University of Hong Kong, Shenzhen.

The research investigates fractional trading’s influence on U.S. equity markets, focusing on three key aspects: 1) its potential to exert price pressure on high-priced stocks; 2) its ability to lower investment barriers for expensive stocks, particularly in the technology sector; and 3) its role in helping retail investors diversify their portfolios. In their study, Da and his co-authors specifically analyzed stocks priced at $100 or more at the end of November 2019, comparing them with lower-priced stocks trading between $5 and $100 per share.

When four brokerages launched fractional trading, they ushered in a new era of investing and trading for retail investors who had been locked out in the past because they lacked enough capital. People from Main Street did not have $1,000 to buy a single share of Amazon. But now, they could buy a small portion of Amazon with just $200 by pushing a button from an investment app.

Interactive Brokers was the first major U.S. brokerage that allowed fractional trading beginning on November 25, 2019, followed by Robinhood on December 12, 2019, Fidelity on January 29, 2020, and Charles Schwab on June 9, 2020, according to the paper.

“Fractional trading lets you bet on several high-priced stocks like Tesla, Amazon, Meta, Netflix and other stocks trading at $1,000 a share,” said Da.

Social media, especially the “r/wallstreetbets” community that had its own chat room on Reddit, fueled the frenzy and attention for GameStop, causing extreme volatility that resulted in the trading of the stock to be halted several times, even though the “average account size for a Robinhood investor was approximately $3,500 in 2021” and “the median account balance was only $240,” according to the paper.

When brokerages allowed fractional trading, the volume of trading also rose, since an investor with $180 could buy 1.8 shares of a company’s stock trading at $100 per share. Before fractional trading existed, the investor could only purchase one share, did not invest at all or sought out cheaper-priced stocks. Less experienced investors, especially Gen Zers, often could not afford to participate in the stock market at all due to a lack of money, Da said.

Da and his co-authors were originally researching the impact of stock splits such as Tesla. When shares of the electric vehicle company’s stock split in 2022, each investor received an additional two shares. The stock split lowered the price per share to $296.07, compared to $891.29 before the split, making it more affordable to retail investors.

With the advent of fractional trading, a reduction in share price is less relevant to encourage retail investors to buy a company’s stock, Da said.

Pros and Cons of Fractional Trading

Fractional trading has its drawbacks since Gen Z is “often influenced by social media and coordinates their trading,” said Da.

When retail investors decide to buy the stock of a company like GameStop at the same time, the situation can produce unintended consequences such as pushing the price of the stock too high and “unnecessary volatility” occurs, he said. The price of the company’s stock rose as much as 100 times over several months in 2021, the paper stated.

“Specifically, we show that tiny trades by fractional trading investors, when coordinated by attention, can cause significant price fluctuations in high-priced stocks,” according to the paper.

Investors without deep pockets who can only invest $100 at a time can buy and sell the same stock more than once, resulting in the price rising quickly in a short period. Stock bubbles such as GameStop, which would not happen otherwise, occur because “the constraint is gone,” Da said. “The price can go up and up and you are much more likely to see bubbles, often from sentimental investors.”

Robinhood’s data showed that fractional trading drew immense interest into Class A shares of Berkshire Hathaway, the conglomerate run by billionaire Warren Buffett, which traded between approximately $325,000 and $330,000 per share in early 2020, according to the paper. The number of Robinhood investors in the stock rose from zero in January 2020 to over 30,000 on August 13, 2020, the paper stated.

“Berkshire Hathaway or $BRK.A is a clear example where you see the footprint and the number of Robinhood investors” increase exponentially, said Da.

One issue that arises is when less experienced investors — especially first-time investors who are overly influenced by social media — start selling and buying stocks. While fractional trading empowers them, the potential can create a lot of “noise” for a single stock, such as popular tech stocks like Apple. The result can be an increase in the volatility of the price of the stock, creating a “bubble” like the meme stocks in 2021, Da said.

“Over a long horizon, the equity market always outperforms bonds and cash,” Da said. “You should always put surplus cash in equity. If you have $50, you should invest it.”

He cautioned against timing the market or following the herd since those investors often invest in stocks that receive a lot of attention through media outlets and social media.

“Be a long-term investor rather than following sentiment,” Da said. “You should fully participate in the equity market. Don’t try to time the next GME bubble. Instead of buying a Starbucks coffee, get a regular coffee. Use the difference to invest in low-cost index-based ETFs than using it to bet on individual stocks.”

Illustration by Carmona Errata. Photo by Michael Catarina/University of Notre Dame.

Published
“Fractional Trading”
Review of Financial Studies
Zhi Da, Vivian W. Fang and Wenwei Lin