When you start learning about investing, you are likely to come across certain terms. You will learn that there are main categories of stocks: Preferred and common. While most of us, when we think of buying stocks, actually think of common stock, it can be profitable to own preferred stock. Here are some of the differences.
Just as the name suggests, a preferred stock is one that comes with special privileges. However, as with many investments that are considered “less risky” and “preferred,” you have a smaller chance of gain.
Preferred stocks are often thought of as being somewhere between “regular” stocks that you would buy on the open market, and bonds. A preferred stock is sometimes seen as a fixed income investment, since one of the characteristics is usually that you end up with regular dividends paid.
Often, preferred stocks are sold on the secondary market. An investor expects to receive certain benefits from preferred stock.
- The dividends on preferred stock are often larger than what you would see with common stock.
- An investor holding preferred stock has a greater claim on the equity of a company, so that means if something goes wrong, preferred stockholders get their investment back before the common stockholders.
- It’s also worth noting that the nature of preferred stock makes price fluctuations less of an issue. These stocks are less influenced by the volatility seen day to day in the stock market. As a result, you are unlikely to see dramatic capital appreciation when you buy a preferred stock.
Many investors who make preferred stock purchases do so with the intention of using them for the dividend income.
As you evaluate a company’s preferred stock, you should look at the ratings associated with the shares. Interestingly, preferred stocks carry ratings that are similar to bond ratings. This goes back to the fact that, in many cases, preferred stock is classed more as a fixed income investment than it is considered an investment designed for capital gains. If you feel that the stock is highly rated, and the issuing company is in good shape, preferred stock can be a reasonably good addition to your income portfolio.
On the other hand, common stock is what you are likely to buy on the stock market. As with preferred stock, you normally get access to common stock on the secondary market. We’re not used to thinking of the stock exchanges as “secondary,” but they are. Companies offer their stocks at initial public offerings, and then when that common stock is sold, it is resold to other investors on the stock exchange. It’s important to note that when you buy stock on a “regular” exchange, you are not providing additional profit to the company; the seller of the stock is receiving the profit.
With common stock, you can potentially earn a dividend. However, this dividend is entirely at the discretion of the company, which might decide to aware its shareholders for keeping the stock. With preferred stock, a dividend is often guaranteed (usually every quarter). With common stock, a dividend is not guaranteed, and some companies don’t ever pay a dividend.
If something happens, and a company becomes insolvent, it may liquidate its assets and buy back its equity to do so. If you are a common stockholder, you will have to wait until after the preferred stockholders have been taken care of. Common stock is often consider riskier than preferred stock.
The advantage to owning common stock, though, is the potential for bigger gains. Common stock is more volatile, and there is a greater chance of capital appreciation. If you are trying to build your portfolio, and grow your nest egg, common stock can be very helpful, since you have a better chance of selling it for more than you acquired if for. Of course, there is also the bigger chance of loss.
Consider the differences between preferred and common stock as you build your portfolio. Think about your goals, and decide which type of investment is most likely to help you accomplish your desired end.
Photo credit: Iman Mosaad.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.