Most people know that stocks are one of the assets that might generate income or return on your investments. However, a less well-known fact is that there are multiple kinds of stocks. The shares you buy could be common stocks, but they could also be preferred stocks.
Most investors buy common stocks. This stock type might be better for generating wealth in the long term. However, common stocks have their pros and cons. For certain types of investors, preferred stocks might offer better advantages.
But what’s the difference between preferred versus common stocks? Learning the answer might help you decide which type of stock to invest in next.
Preferred vs. common stocks
If you plan on investing money for the long term and are looking for the greatest potential to earn a return over several years or perhaps decades, common stocks might be a better fit.
However, the higher return potential comes with higher potential volatility and risk. Investors who prefer more predictable returns and like to receive dividends may opt for preferred stocks. These stocks often offer a higher dividend yield.
How do preferred stocks work?
Preferred stocks are a type of stock that acts more like debt, or a bond, than a stock. This bond-like nature means its main feature is its dividend payout since its growth potential is limited. Preferred stock prices are less likely to increase over time the way they could for common stocks.
Pros of preferred stocks
Preferred stocks have a higher priority in receiving dividends than common stocks. In fact, companies pay preferred stock dividends in full before common stockholders receive their dividends. Preferred stocks also tend to have higher dividends than common stocks.
Dividends for preferred stocks are percentages of their par value, which is the value they’re given in official corporation filings and is usually different from their market value. This could make their dividends more predictable, although the exact percentages might vary.
If a company that issued preferred stocks faces liquidation, preferred stockholders usually have a priority when receiving a payout over common stockholders.
Cons of preferred stocks
Preferred stocks do have their downsides. For example, they have no voting rights, unlike common stocks.
However, the biggest downside for growth-oriented investors might be their limited growth potential. While preferred stocks offer predictable dividends, the growth of this type of stock tends to be more modest when compared to common stocks. This is due to their predetermined call prices, which may limit their growth.
In addition, preferred stocks usually come with a call date. That date is often five years after the preferred stocks are issued. This allows the company issuing the stocks to repurchase them after that date. If the issuer decides to call their preferred stocks at a call price lower than their market value, you might end up with a lower return.
Lastly, preferred stock prices usually have an inverse relationship with interest rates. If interest rates increase, preferred stock prices tend to decrease. The reverse also tends to be true.
How do common stocks work?
Common stocks are a class of stock that gives common shareholders voting rights, specifically, one vote per common share. This stock type is what a company usually issues, hence the name.
Pros of common stocks
Since common stocks provide voting rights, their owners get to vote at stockholder meetings to elect the company’s board of directors. Stockholders could also influence other key decisions to a company’s profitability.
Unlike preferred stocks, investors tend to buy common stocks for the chance that these stocks could increase in value. The potential value appreciation is theoretically unlimited and is subject to market supply and demand.
This higher growth potential comes at the cost of higher volatility. That’s why time in the market matters, making common stocks potentially advantageous as a long-term investment.
In addition to receiving returns on higher values, common stockholders may also receive dividends, but they only do so after preferred stockholders have been paid in full.
Cons of common stocks
Common stockholders only receive dividends from the company’s earnings, meaning that they would receive dividends if the company were profitable. Hence, dividends might not be guaranteed for common stockholders.
Common stocks could also be quite volatile, and those who hold common stocks might lose more than preferred stockholders. That’s why common stocks are considered a riskier investment option.
What both stocks excel at
Preferred and common stocks both offer several potential advantages for investors. Here’s why both might be a wise investment:
Both common and preferred stocks represent ownership in a company.
Both types of stocks might see a valuation increase over time.
Both preferred and common stocks could pay dividends.
Both types trade on the stock market.
4 important differences between preferred and common stocks
There are several important differences between preferred versus common stocks. Here are the main differences to keep in mind when you’re learning how to invest in stocks.
Investors looking for stocks that pay consistent dividends may opt for preferred stocks. This is because preferred stockholders receive dividends before common stockholders do. In addition, preferred stocks receive higher dividends than common stocks issued by the same company.
Common stocks may receive dividends, but only after all preferred stockholders have been paid. If money remains from the company’s earnings, common stockholders may receive payouts.
2. Growth and volatility
While common stocks could be more volatile than preferred stocks, they also have greater growth potential than preferred stocks. If you are looking to grow your investment over the long term, common stocks might be a better choice.
However, keep in mind that common stocks are considered capital assets by the Internal Revenue Service. You’d pay taxes on your gains, effectively reducing your earnings. Learning how to avoid capital gains tax or reduce them might help you keep more of these gains in your pocket.
3. Voting rights
Each share of common stocks usually comes with one vote, which entitles you to vote at shareholder meetings. Preferred stocks don’t come with any voting rights.
4. Claim over company’s assets
If the company you invest in goes bankrupt, preferred stockholders are paid their share of the liquidation value before common stockholders. While common stockholders are the last in line to be paid out.
Which stocks should you choose?
For most investors, the choice between preferred and common stocks depends on their financial goals.
Preferred stocks might provide more consistent performance and regular dividend payments, while common stocks may be more volatile. However, common stocks might provide greater returns in the long run because there is almost no limit to how much their share prices could increase.
For example, let’s consider the performance of a popular common stock fund against the performance of a preferred stock fund.
The SPDR S&P 500 exchange-traded fund (SPY) holds common stocks of the biggest 500 publicly-traded companies in the United States.
The iShares Preferred and Income Securities exchange-traded fund (PFF) tracks the performance of several preferred stocks and hybrid securities.
In the past 10 years, the market price of PFF has slightly declined. Meanwhile, the price of SPY has increased about three fold. However, PFF paid a dividend of 4.47%, while SPY paid a dividend of 1.46%.
Common stocks might offer higher rewards if you have a longer time horizon and a higher risk tolerance. But for those who prefer to get a fixed income and can’t wait for a price increase, such as retirees, preferred stocks might be the right fit.
They also fill a similar role to government bonds by paying a relatively stable dividend or interest. They might be a good fit as semi-stable assets in a diversified portfolio that might reduce your risk.
FAQs about preferred vs. common stocks
What is an example of common stocks?
Most public companies issue common stocks, so there are many examples. You could, for example, learn how to buy Nvidia stock (NVDA), which is a common stock that trades on the NASDAQ exchange.
What does 6% preferred stock mean?
6% preferred stock means the annual dividend yield or payout is 6% of the stock’s par value, which is the value listed in the official corporation filing. A 6% yield might refer to a fixed dividend rate, but some preferred stocks might come with an adjustable rate.
Why would you buy preferred stocks?
You might buy preferred stocks if predictable returns are more important to you than long-term performance. Preferred stocks tend to pay more consistent quarterly dividends than common stocks.
Those dividends might also be higher than common stock dividends. However, preferred stock investors may not experience the same price growth that common stockholders may see over time.
How do you know if a stock is common or preferred?
It is not always obvious if a stock is common or preferred. The biggest clue might be an extra P in the stock ticker. For example, Presidio Property Trust has common stocks with the SQFT ticker. But it also offers preferred stocks, which have the SQFTP ticker. You may also see PRF or preferred shares in the stock name or description.
Both preferred and common stocks have several advantages for investors. Preferred stocks could be less volatile and provide consistent dividends, but their prices are less likely to increase over time.
On the other hand, common stocks could provide greater returns in the long run, but they have smaller dividends and are often riskier. Hence, the best choice depends on your investment goals.
What both have in common is their ease of access. You could buy preferred and common stocks online since they’re listed on public stock exchanges. Explore the best investment apps to find one that offers the most advantages, or use one of the best brokerage accounts to benefit from low trading fees.
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This article Owning Preferred vs. Common Stock: 4 Key Differences originally appeared on FinanceBuzz.