Preferred Stock Vs. Common Stock: A Comprehensive Guide

As an investor, you may have heard of preferred stock and common stock, but do you know the difference between the two? In this guide, well compare preferred stock and common stock so you can make informed decisions about which type of stock is right for your investments.

Common Stock Has Voting Rights

Common stocks are perhaps what most people think of as buy-and-hold investments when the stock market is mentioned. They represent a slice of ownership in a company. By owning a company's common stock, you essentially become a shareholder, and this position offers both potential rewards and risks. Common stockholders are entitled to vote at shareholder meetings and are privy to dividends, but these dividends arent guaranteed. Instead, the payment and amount depend on the company's profitability, decided upon by its board of directors. Also, when it comes to the pecking order during bankruptcy, common stockholders stand last, receiving whatever remains after all other stakeholders have been paid. However, with these risks comes the potential for higher rewards. Common stocks generally have a greater potential for price appreciation, making them attractive to investors with a higher risk tolerance.

Preferred Stock Has a Priority

In contrast, preferred stocks present a different set of opportunities and drawbacks. While they, too, represent a portion of ownership, they don't come with the voting rights that common stocks usually provide. Instead, their allure lies in the dividend. Preferred stockholders are generally promised a fixed dividend, and this is where the term preferred comes into play. If a company chooses to pay dividends, preferred stockholders receive theirs before common stockholders. In scenarios where the company faces bankruptcy after a stock market bubble, preferred stockholders are also ahead of common stockholders in the line to claim the company's remaining assets. The dividends and prioritized claims make preferred stocks seem less risky, but this comes at a price. The potential for price appreciation is often less compared to common stocks, making them more suited for investors prioritizing steady income over significant growth.

Some Preferred Stocks Can Be Converted

However, the world of preferred stocks is not monolithic. Certain preferred stocks offer the option to be converted into a fixed number of common shares. Known as convertible preferred stocks, these offer investors the flexibility to capitalize on the potential upside of a company's common stock if they believe in its future prospects. This feature can make preferred stocks attractive to both income-seeking and growth-oriented investors. Yet, another point of distinction is how these stocks react to market dynamics. Common stocks are notably more volatile, with their prices swinging in tandem with the company's performance, market speculations, and broader economic indicators. Preferred stocks, due to their bond-like characteristics, especially the fixed dividends, tend to be less sensitive, making their prices more stable in comparison. This makes them akin to cash flow investments.

Preferred Stock vs. Common Stock: The Pros & Cons

When comparing preferred stock and common stock, there are a few key differences to consider. On one hand, preferred stock offers a more predictable return and lower volatility than common stock. On the other hand, common stock offers more potential for high returns but also carries greater risks.

Preferred Stock Pros

Lower volatility than common stock.

Fixed dividend rate makes it easier to predict returns and plan accordingly.

Priority over common stock when it comes to dividends and asset distribution.

Preferred Stock Cons

No voting rights.

Not entitled to any additional payments if the company is sold or liquidated.

Common Stock Pros

Owners of the company with voting rights.

More potential for high returns if the stock price goes up.

Common Stock Cons

Last in line when it comes to receiving dividends.

Higher volatility than preferred stock.

No fixed dividend rate, making it harder to predict returns.

Which Type of Stock is Right for You?

So, which should an investor choose? The answer is seldom black and white, as it depends heavily on individual goals and risk appetite. For those who view investments as a vehicle for steady income, preferred stocks can be an attractive choice. Their fixed dividends can offer consistent, albeit potentially lower, returns. On the other hand, investors looking for opportunities to grow their capital might be more drawn to common stocks. While riskier, the potential for capital appreciation is significantly higher. Its also worth noting that there isnt a one-size-fits-all answer. A diversified portfolio can very well hold both preferred and common stocks. This blend allows investors to balance out the risk and rewards, hedging against market downturns while still having a stake in potential high-reward scenarios.

Conclusion

Both preferred and common stocks serve as foundational elements in the world of investments. While they share the basic premise of representing company ownership, their differences are vast, influencing the dividends, voting rights, liquidation preferences, volatility, and appreciation potential. As always, prospective investors should consider their financial goals, risk tolerance, and investment horizon before making a decision. Understanding the intricacies of these stocks can pave the way for informed and strategic investment choices. Preferred stock and common stock both have their advantages and disadvantages, and its important to understand the differences before making any investment decisions. Preferred stock offers a more predictable return and lower volatility, while common stock offers more potential for high returns but also carries greater risks. Ultimately, the decision of which type of stock is right for you will depend on your investment goals and risk tolerance.