Investing in the stock market is a good way to grow your retirement savings and build wealth, so that you can achieve your financial goals. The challenge, of course, is that many beginning investors don’t have a lot of knowledge about the various types of stocks. They may be unsure about what to buy when it comes to making a smart investment.
We always want our Addition Financial members to feel empowered and knowledgeable about their money. We reached out to some experts who understand the ins and outs of investing to ask them to explain the differences between preferred vs common stock. Here’s what they told us.
What is Common Stock?
Let’s start with one of the most important stock market basics: what is common stock? Common stock is a type of security that confers a partial ownership stake on the buyer. In other words, if you purchase common stock, the stock itself represents a portion of the value of the company that issued the stock.
The ownership element of common stock means that as a common shareholder, you have voting rights. Company shareholders hold regular meetings and each common stockholder can vote on the board of directors and to determine corporate policies. They may also vote to approve stock splits. A stock split occurs when a share of stock is divided into multiple shares to improve a company’s liquidity.
Many publicly traded companies offer various types of stock, including bonds, common stock and preferred stock. An example of common stock is Microsoft, which trades on the NASDAQ exchange as MSFT.
What is Preferred Stock?
Now let’s talk about preferred stock. Preferred stock, as the name suggests, offers some preferential treatment to shareholders. Holders of preferred stock earn higher dividends than holders of common stock. They will also get their money before common stockholders in the event of a liquidation.
Preferred stock may specify a dividend amount that will be paid to shareholders. In some cases, companies issue preferred shares as a way of protecting themselves against takeover ownership. Preferred stock can provide equity financing without any sacrifice of control or voting rights.
An example of a company that offers different classes of preferred stock is insurance giant Allstate, which trades three preferred stocks on the market, listed as ALL-G, ALL-H and ALL-I.
What are the Key Differences Between Common and Preferred Stock?
The key differences between common and preferred stock should already be taking shape in your mind, but let’s break them down before we get into the advantages and disadvantages of each.
- Both types of stock may pay dividends, but common stock dividends are usually tied to the value of a company while preferred stock dividends are not.
- Common stockholders have voting rights, giving them a say in electing board members, deciding on corporate rule changes and stock splits, while preferred owners have no or limited voting rights.
- Preferred stockholders get preferential treatment if a company liquidates, while owners with common stock will receive a share only after bondholders and preferred stockholders have been paid.
There are good reasons to buy both common and preferred stock when you are creating your portfolio. Each type of stock has its benefits and risks and buying both can help you to balance your portfolio and give you the opportunity to build wealth over time.
What are the Advantages of Preferred and Common Stock?
Now, let’s talk about the advantages and disadvantages of preferred and common stock. We asked four financial experts to share their thoughts. Reading what they said may help you to understand the differences and determine how to build a portfolio that will allow you to grow your money without taking unacceptable risks.
Shannon Terrell
Shannon Terrell is a Senior Investments Writer at Finder. This is what she told us about preferred vs common stock:
“Preferred stock's biggest advantage is that dividend payments are prioritized over common stock. And they expose investors to less volatility – with the caveat that the returns are typically smaller.”
A company may specify a dividend payment for preferred stock. That means when it comes to dividends, a preferred stock may have a lower risk – and a lower reward – than common stock. In this way, they are more like bonds than stock.
For example, a preferred stock may promise to pay a dividend on a quarterly basis. Dividends for common stock may come less frequently. However, if a company’s value rises dramatically, common shareholders may earn more since their dividends are tied to the stock’s performance instead of being set ahead of time.
Jenna Lofton
Jenna Lofton is a Certified Financial Advisor with StockHitter.com. She went into detail about the issue of dividends, as well:
“Preferred stock has the advantage of a higher guaranteed dividend than common stock. With that said, they do not have to meet any specific earnings target for these dividends to be paid out whereas common stock may have their dividend suspended if desired by the board of directors.”
She also added some information about warrants, which are something you should be aware of before buying common or preferred stock:
“Another difference is that preferred stocks tend to carry warrants (a set amount of shares per every 100 stocks) which can end up granting extra voting power and/or capital gains.”
A warrant is like a stock option. It offers preferred shareholders the option of buying additional stock at a guaranteed price, usually a price lower than the cost of common stock. If the company’s stock prices go up and you exercise your warrant, you can buy the stock at a below-market price and realize greater profits. There is some risk involved because if the stock price drops below the warrant price, the warrant loses its value.
Ann Martin
Ann Martin is the Director of Operations at Credit Donkey Crypto. She focused on both dividends and voting rights in her advice:
“When you own preferred stock, you are eligible to receive dividends before shareholders with common stock. However, common stock generally comes with voting rights for shareholders while preferred stock does not.”
The issue of voting rights is important for some shareholders. Some investors prefer to take an active role in the companies whose stock they own. If that’s something that appeals to you, then you may want to focus on acquiring common stock instead of preferred stock.
Raj Patel
Raj Patel of Financeshed mentioned preferred stock dividends as well, but he also zeroed in on a key difference related to the similarities between preferred stock and bonds. He told us this:
“Preferred stocks’ return on investment is good if you hold them to maturity, same as the bonds, while value of the common stocks can be wiped out.”
You may already know something about bonds. When you buy a bond, it is usually at a discounted price. The bond has a term, at the end of which it reaches maturity. At that time, it may be sold for the face value. Or, you can hold onto it past its maturation date and if the value increases, you may earn more for it.
The issue of volatility is one that looms large for many investors. It’s important to weigh the risk and reward of common vs preferred stock. The long-term earning potential of common stock is worth the risk for some people. If a company’s value increases, the return of investment for common shareholders may outpace those of preferred shareholders.
Should You Buy Common Stock or Preferred Stock?
The decision to buy stock should always be made with care and consideration. Here are some things to consider before you buy:
- Portfolio diversification is always a good idea, and many investors opt for a combination of bonds, common stock and preferred stock in different sectors to minimize their risk.
- For slow and steady growth, bonds and preferred stock may be preferable to common stock. You are less likely to lose money on these securities.
- For long-term growth, common stock can be ideal. Because dividends are tied to a company’s growth and profitability, the earning potential can be significantly larger than it would be with preferred stock or bonds.
- For people who prefer to take an active role in their investments, common stock offers voting rights and the potential to impact a company’s growth and trajectory over time.
- If your risk tolerance is low, then you may want to focus more on bonds and preferred stock, trading some of the growth potential in your portfolio for security.
As a smart investor, you’ll need to balance your risk tolerance with your long-term financial goals to determine how much common stock and preferred stock to buy.
Investing in the stock market is one of the best ways to ensure you have the money you need for a comfortable retirement. Choosing a combination of preferred and common stock can help you earn steady income while also allowing the potential for significant long-term earnings.
Do you need some help choosing investments and building your portfolio? Click here to learn about Addition Financial’s MEMBERS Financial Services program and schedule an appointment with a CUNA Financial Advisor.
