When it comes to buying a company’s stock, you have two options: you could buy common stock, or preferred stock. Common stock gives you certain voting rights, and you earn money when the value of your stock goes up. Preferred stock, on the other hand, is more like a fixed income investment. You get a set dividend payout, but the value of your stock doesn’t appreciate immensely over time.
If you’re wondering which type of stock is a better fit for your investment goals, let’s take a look at both and see.
What is common stock?
Common stock represents ownership in a company. When you own shares of a company’s common stock, you have the right to vote on certain issues, such as the company’s board of directors, as well as mergers.
Of course, most investors don’t buy common stock to vote on major corporate decisions. Instead, they buy common stock to capitalize on its price appreciation. As a common stockholder, the value of your stock can rise considerably over time as the company expands and becomes more profitable. If you buy common stock when the price is low and sell when it’s high, you could earn a hefty amount of money.
Of course, the converse is true, too. Your common stock could drop in value, causing you to lose money. In this sense, common stock is more volatile than preferred stock, as the value of your stock can change rapidly and unpredictably.
What is preferred stock?
Preferred stock pays a fixed dividend (like a bond) on a regular schedule, but trades on an exchange (like a common stock). Though common stock may offer you a dividend payout, the dividends on preferred stocks are typically much higher. And since the dividends on preferred stocks are fixed, you don’t have to worry about them fluctuating over time.
Preferred stock comes with a “par value,” which is a set minimum price that the company states in their charter. The par value is important as it helps you calculate your preferred stock’s dividend. For instance, if your preferred stock has a par value of $25 with an annual dividend of 10%, you’d get $2.50 per year in dividend payouts.
Many preferred stock are redeemable, which means a company has the right to redeem the stock at any point after a specified date. Often companies will redeem preferred stock when interest rates drop (which makes the preferred stock more valuable), then reissue the preferred stock with a different rate, usually lower than the original.
Why are they called “preferred” stock?
Preferred stocks are called “preferred” because shareholders typically enjoy certain advantages over common stockholders.
For one, preferred stockholders always receive their dividend payouts before common stockholders. That means, if a company decides to cut their dividend, they will always cut the dividend of common stockholders before their preferred counterparts.
Secondly, if a company goes bankrupt, the company will always repay preferred stockholders their share in stock before common stockholders. It’s important to note, however, that preferred stockholders aren’t first in line. They stand behind bondholders and creditors, who will receive repayment first.
What are the main differences between common stock and preferred stock?
Though both preferred stock and common stock represent ownership in a company, they work very differently. Here are the main points of difference.
|Feature||Common Stock||Preferred Stock|
|Rank in company’s capital structure||Behind preferred stockholders||In front of common stockholders, but behind bondholders and creditors.|
|Upside potential||Unlimited||Limited to redemption value|
|Downside risk||Can drop to $0||Less likely to drop to $0|
|Volatility||More drastic price movements||Less drastic movements|
To sum it up, common stock is more risky than preferred stock, but its capital appreciation could far outweigh what you earn on a fixed dividend. With common stock, you also get certain voting rights, whereas with preferred stock you don’t.
Likewise, though preferred stock doesn’t have unlimited upside potential, it does offer fixed, regular dividend payouts for a specific period of time. Common stockholders may also get dividends, but they can vary or worse – be cut altogether.
Should you buy preferred stock?
Preferred stock is great for investors who want a fixed-income investment. It can also be attractive for investors who want a stock that pays a higher dividend than common stock.
In general, the best time to buy preferred stock is when interest rates are low. When interest rates are low, the par value on preferred stock goes up, and they typically pay out at a higher rate. The converse is true, too. When interest rates are high, preferred stock begins to lose value.
If you want to buy preferred stock, you can purchase it through any brokerage account. Keep in mind that the ticker on preferred stock will be different from a company’s common stock (you don’t want to accidentally buy common stock, if you’re set on purchasing preferred stock). Also, because most companies issue common stock, the market for preferred stock is small and limited to a few companies.
Should you buy common stock?
Investors who want to earn immense gains from their investments should look no further than common stock. Common stock doesn’t offer you a fixed-income investment, but it does offer unlimited upside potential. As a common stockholder, you have the opportunity to buy great stocks when the prices are low, then sell your shares years later (sometimes decades) for a price higher than the one you paid. This capital appreciation is what helps average investors build wealth over long periods of time.
Before you invest in common stock, however, you should know your risks. For one, common stock is more volatile than their preferred stock counterparts. That means, the value of your investment could fluctuate immensely over short periods of time. Likewise, if a company goes bankrupt, it’s unlikely you’ll get compensated for the value of your common stock: you sit in line after creditors, bondholders, and preferred stockholders, all of whom have to get paid before you do.