Preferred stock and common stock are two different classes of shares that publicly traded companies may issue.
It’s important to understand the difference between common stocks vs preferred stocks so that you can properly evaluate potential investments and determine whether they fit into your overall portfolio strategy.
What are Common Stocks?
Common stock is what people generally think of when they refer to a stock. All publicly traded companies issue common stock, which provides you a share in a company with the requisite voting rights in that company.
Common stocks may offer dividends if the company chooses and can also increase (or decrease) in value based on the stock price. If a stock increases in value from when you bought it, then you may be able to sell the stock for a profit.
But dividends are only paid out if the company decides to distribute earnings via dividends to shareholders. If the company goes bankrupt, common stockholders will be paid last, if at all, after creditors and preferred stockholders.
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What are Preferred Stocks?
Preferred stock also represents a share in a company but it has a few characteristics that make it similar to a bond. Preferred stocks, sometimes referred to as simply “preferreds” pay an annual dividend that companies determine in advance and pay ahead of dividends to other shareholders.
Those dividends are often a fixed amount but can be adjustable based on preset specifications. (Dividends on common stock vary based on the company’s finances.) That means preferred stockholders receive dividends whether the stock loses or gains value.
Preferred stockholders also get preferential treatment in the case of corporate bankruptcy or collapse. Preferred stock, however, does not generally come with voting rights, and the company can buy back preferred stock at a predefined price.
Convertible Preferred Stock
Convertible preferred stock may convert to common stock in a few scenarios: if the board of the company votes for conversion, if you decide to convert based on the stock price, or if at a predetermined price date. Private companies often issue early investors preferred, which converts to common stock if the company completes an initial public offering (IPO).
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When companies have a lot of convertible preferred stock or convertible bonds it can impact the way that investors value them. In that case, investors may look at both the company’s earnings per share and their diluted earnings per share, which factors in the potential impact of what would happen if all their convertible securities were turned into common shares.
Why Companies Issue Preferred Stock
Companies may issue preferred stock for several reasons, including a desire to access more capital without taking on more debt or diluting existing voting rights. Companies may also consider preferred stock less risky, since they may have the option to call it at a later date.
Preferred Stock vs Common Stock: Benefits and Drawbacks
When looking at preferred vs common stock, both have benefits and drawbacks, and both can be good investments depending on your overall strategy.
Preferred Stocks Benefits
• Higher Dividends. Preferred stock typically pays higher dividends than common stock because the company sets dividends when issuing the stock. However, if the company decides to issue a more significant dividend, the dividend on a common stock could go above the dividend on preferred stock.
• Less Volatility. Given their guaranteed dividends, preferred stock may have less price volatility than common stocks, while remaining more volatile than a bond.
• Preferred Stockholders Have Priority. One of the things that makes preferred stock slightly less risky is what happens in the case of a company becoming insolvent. If a company has to declare bankruptcy and pay creditors and bondholders, then preferred stockholders get paid before those who have common stock in the company.
Preferred Stock Drawbacks
• Interest Rate Risk. Because preferred stocks have many similarities to bonds, their value correlates to interest rates. Thus, as interest rates rise, preferred stock becomes slightly less valuable because other investments may appear to be more valuable.
• Limited Growth Potential. Although preferred stocks may have higher dividends than common, they may not have the same upside. Investors are more likely to see stock appreciation with common stock than with preferred stock. So, if investors are looking for a long-term strategy, they might be better off with common stock.
• Potential for calls. Companies may be able to call or redeem convertible preferred stock, meaning you’d get paid for the value of the stock but would no longer own it. The stock may also convert to regular stock.
Common Stock Benefits
• Voting Rights. The voting rights that come with common stock may not be especially valuable unless you own enough stock to have a significant percentage of voting rights, but some investors enjoy the opportunity to make their voices heard.
• Appreciation. Common stocks are more likely to appreciate than preferred stocks. So, for investors wanting to capitalize on a company’s growth potential, purchasing common stocks can help them achieve this goal.
• Availability. While every publicly traded company offers common stock, not every company offers preferred stock
Common Stock Drawbacks
• Volatility. Common stock’s value can go up or down depending on the company. That means that common stock may have greater investment risk, with the potential for both greater gains and greater losses.
• No Dividend Guarantee. Common stock does not guarantee a dividend, which means it won’t provide a set income, although some stocks do provide relatively reliable dividends.
When You Should Buy Preferred Stock vs Common Stock
When evaluating the difference between common and preferred stock, preferred stocks may appear to be a better deal, given their guaranteed dividends and preferred access to assets if the company goes bankrupt.
Whether or not investing in preferred stocks is suitable for your portfolio will depend on your investment goals and risk tolerance. For example, if you’re looking for a steady stream of income, a preferred stock might make a good addition to your portfolio since they have the potential to offer higher and consistent dividends.
On the other hand, if you’re looking for more of a long-term growth strategy to save for retirement, there might be better options since companies can call back their preferred stock and common stock may have more potential for gains.
As with any investments, there is no guarantee for either common stocks or preferred stock. Before you decide which is better for your investment mix, determine what role they will play in reaching your financial goals.
Common vs Preferred Stock: Getting Started Buying Stocks
Whether you’re buying preferred or common stocks, you can make the purchase via a broker licensed to trade on the exchanges, or using an online trading platform that allows you to make individual trades yourself or invest in a diversified fund made up of a mix of stocks, bonds, and other assets.
Whichever way you go, it’s often easier to access common stocks, but you can get exposure to both through ETFs (exchange-traded funds) as well. There are preferred stock ETFs, which offer the ability to buy a share of the ETF, granting a proportionate share of all the preferred stocks that make up that ETF.
Individual investors don’t have access to all preferreds. Participating preferred stock is a special type of preferred stock typically only available to private equity or venture capital firms making an investment in an early-stage company.
If this all sounds a little complicated, then professional advice can also help you figure out how stocks—both preferred and common—can fit into a diversified portfolio that helps you achieve your financial goals.
The SoFi Invest® brokerage platform offers both active investing and automated investing, which means you can either pick and choose your own stocks or you can have an algorithm help set you up with an investment portfolio tailored to your risk tolerance and goals.
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