Savvy investors should understand the differences between common stock and preferred stock. While the two share similarities, they each possess different attributes that can affect any investor’s portfolio. Read on to learn how these two types of investment vehicles compare and contrast.
Should Investors Prioritize Preferred Stock?
As the name suggests, preferred stock receives preferential treatment over common stock in certain instances, such as when it comes to both dividend payments and rights upon liquidation. Owners of preferred stock will receive any payments owed prior to owners of common stock, making it a relatively safer investment.
Here is how these preferences play out:
Dividends: Owners of preferred stock will receive priority for dividend payouts, prior to owners of common stock. In addition, these dividends are generally pre-determined, making them a good choice for investors looking for stable, more predictable returns.
Similarly to bonds (see below), preferred stock is often issued at a par value, also know as the nominal or original value. If the price of the preferred stock goes up, this means that it is trading above its par value. The same is true if the price goes down, which will mean that the stock is trading below its par value. The dividend will usually be based on the original value, removing uncertainty and to a certain extent decoupling dividend payments from the company’s performance (for better or for worse).
However, there could be periods when the company is struggling and unable to issue dividend payments. If the preferred stock is cumulative, this means that preferred shareholders must eventually be compensated for any dividend payments they might have missed. These payments will be prioritized ahead of those that are owed to the holders of common stock.
Additionally, convertible preferred stock allows the owner of these shares to convert their preferred holdings into common stocks, usually after a predetermined amount of time has passed. This allows owners of preferred stock to more fully partake in the benefits of the company’s growth if they choose to do so. This can cut both ways, however, and companies often have the option to redeem these shares by repurchasing them.
Liquidation: Owners of preferred stock are also prioritized in the event that the company is dissolved. The significance of this is that preferred stock owners will receive payments prior to owners of common stock, who will only be compensated after these owners of preferred stock have been paid.
Similarly to common stock, preferred stock is also traded on exchanges and can be purchased and sold in much the same way. The symbols for preferred stock will be similar to those for common stocks, usually with an extra letter or two to signify the difference between the two types of assets.
What are the Advantages of Common Stock?
Although common stock has fewer protections than preferred stock, the benefits can be greater as well. Common stock dividends can be more lucrative, as their payouts are usually intrinsically tied to the performance of the company and the amount of profits and revenues it is bringing in.
In addition, common stock affords its owners more of a say in the direction of the company. Owners of common stock have the ability to vote for the membership of the board of directors, usually correlating to one vote per share. While this might not be as important for smaller investors possessing limited amounts of shares, larger investors with more of an ownership stake might be more interested in helping to define company leadership.
Lastly, common stock tends to be more, well, common than preferred stock. This makes it more of a liquid asset, easier to both buy and sell when compared to preferred stocks. For the most part, there are not too many options to purchase preferred stock, with financial institutions the most common (ahem) issuers.
How Does Preferred Stock Compare with Bonds?
There are a number of similarities between preferred stocks and corporate bonds, especially regarding the relative safety and stability of the investment. The dividend-payment (in the case of preferred stock) and the interest rate (for corporate bonds) are usually pre-defined, making both of these good options for the more risk-averse.
Because corporate bonds and preferred stocks are considered safer than common shares, they are also more sensitive to interest rate changes. When interest rates rise, investors have other options to receive higher returns in more secure investments such as Certificates of Deposit and high yield savings accounts. As these lower risk options become more attractive, corporate bonds and preferred stocks can become less inviting, driving down their value accordingly.
Another important distinction is that both preferred stocks and corporate bonds will be paid prior to holders of common shares in the event that the company becomes insolvent and needs to shutter its doors.
However, there are some key differences between these two types of assets as well.
In the hierarchy of investors, bond holders will be favored over preferred stocks. In other words, in the event that a company is struggling or going under, bond holders will be compensated before owners of preferred stocks (who will in turn be paid before those holding common shares).
In addition, corporate bonds have a maturity date at which point the company must pay its bond holders. Preferred stocks may or may not have a call date when they will be redeemed, meaning that these investments can be held onto in perpetuity.
Conclusion: Making the Right Investment for You
The difference between preferred stock and common stock essentially comes down to the age-old question of risk verses reward. Preferred stocks offer another feature of security for your investments, making them similar to corporate bonds in many respects.
With every portfolio, diversification is usually a good move. Strategies such as a 60-40 portfolio is one such pathway, and both common and preferred stocks can help you achieve your desired investment balance. In fact, by sharing attributes of both common stocks and bonds, preferred stocks can serve as a good middle ground.
Whichever approach you choose, make sure to check out TipRanks‘ slew of tools and information to help you on your investment journey.
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