Katherine Gustafson is an author and personal finance expert from Portland, Oregon. She writes about investing for Wealthsimple as well as having written for Forbes, Business Insider, TechCrunch, and LendingTree. Katherine is a past recipient of the Izzy Award for outstanding achievement in independent media. She has a BA from Amherst College and an MA from Boston University.
The stock market may seem intimidatingly complex, but it should be reassuring to hear that stock traded on the open market really only comes in two main types: common and preferred. They have their most important characteristic in common—that is, owning a share of either one means you own a little portion of the company that issues the stock.
Common stock and preferred stock are quite different, though, in part because of how much of a risk each represents. Let’s take a closer look at these stock types to get a better handle on the advantages and disadvantages of each.
What are common stock and preferred stock
Common stock and preferred stock are have some similar characteristics but also operate in distinct ways.
Common stock, the most… well, common type of stock out there, is a share of a company’s property and earnings, which investors buy at a price dictated by the market. The prices of stocks go up and down, shifting every few seconds, which means that a central way of making money on stocks is selling the stock at a higher price than the amount you paid for it. That price increase is called appreciation. (Some stocks also come with dividend payments, as determined by a company’s board of directors.)
Holders of common stock have certain rights regarding their ownership and participation within a company. They usually get voting rights within the company that come with a particular number of votes associated with each share of stock. They also get “preemptive rights” to own a consistent percentage of the company regardless of how much stock the company issues. If the company sells a new stock offering, existing shareholders have first refusal to buy as much stock as it needed to maintain their ownership percentage.
To understand preferred stock, you first need to be familiar with bonds. A bond is a formal agreement between a lender and investor about a loan, usually one made by a corporate or government entity. It’s basically an I.O.U. that a lender issues a borrower, which includes all the fine print of the loan. A bond offers regular income to the investor as the borrower pays back the loan.
A preferred stock is like a combination of a common stock and a bond, since it has elements of both. As with owning a common stock, owning a preferred stock means you own a portion of the company. But as with investing in a bond, owning a preferred stock provides you a regular amount of income via a recurring dividend.
Preferred stock comes with a par value, a set minimum price that is stipulated in a company’s charter. The amount that investors earn in dividends is figured as a percentage of this par value. For example, if the par value of your preferred stock is £150 and your annual dividend is 15 percent, the stock would pay out £22.50 per year.
Unlike bonds, however, preferred stock is traded on the market and can appreciate to some extent. Unlike common stock, preferred stock comes with no voting rights but confers on shareholders a higher priority claim on the company’s assets and income. In the case of the company’s insolvency, preferred stock holders get first claim (after bondholders) on any funds raised by liquidating assets.
One type of preferred stock is termed “callable,” which means that the company that issued the stock has the right to repurchase the stock after a certain date and for a set price. That set price is usually higher than the par value by an amount referred to as the “call premium,” which compensates the investor for taking the greater risk inherent in a callable preferred stock.
Key differences between common stock and preferred stock
If you want to buy shares of a company, either common stock or preferred stock will fit the bill. But which one you choose will depend on the goals you have for your investments and your tolerance for risk.
Here are the main differences between these two types of stock:
Common stock is the riskier of the two, and accordingly it is more likely to provide a large return.
Preferred stockholders get fixed, regular dividend payments for a set timeframe, while common stockholders may or may not receive these payments, which are likely to be variable.
Common stockholders have voting rights in proportion to their ownership stake, while preferred stockholders lack voting rights.
Preferred stockholders have a greater claim to the company’s assets than common stockholders.
Preferred stock may be callable, forcing investors to relinquish their shares, while common stock cannot.
Let’s break that list down to pull apart the advantages and disadvantages of these two types of stock.
Advantages and disadvantages of common stock
Common stock’s main advantages are:
Potential for large profit with appreciation
Its disadvantages include:
Potential for loss when the stock loses value
Potential for loss in case of insolvency
May not have dividend payment, which will be variable
Low priority for payments, after bondholders and preferred shareholders
Advantages and disadvantages of preferred stock
Preferred stock’s advantages are:
Regular dividend payments
Priority for payments, after bondholders
Potential for limited profit with appreciation
Its disadvantages include:
No voting rights
Little potential for large appreciation
May be unavailable, as preferred stock is not particularly common
Rising interest rates, which may make it less attractive than other investments
Investing in common stock and preferred stock
Investing in these two types of stock involves the same process, so it’s essential to make sure your market order is for the type of stock you want.
How to invest in common stock
Investing in common stock is a straightforward process, known as trading. As with any investing, start with research about the company or companies you may want to invest in. Also get set up with a method of trading. This could be an investment manager or financial planner or an online trading platform, including a robo-advisor service like Wealthsimple.
Once you decide which stock you’d like to buy, make an order via your broker or the online service you’re using. You’ll be purchasing the shares of common stock from other investors in the market who are interested in selling at the price at which you’re willing to buy. The price of common stocks shift every second, and can rise and fall quickly, so trading is a split-second business. An online brokerage service is a good way of transacting quickly.
Once you’ve put in the order and made the trade, you’re the proud owner of shares of common stock of whichever company you’ve chosen to invest in. Now it’s time to sit back and wait to see what the stock does. Will your investment pay off?
How to invest in preferred stock
Investing in preferred stock involves the same process to invest in preferred stock as it is to buy common stock, and it’s very common to use an online brokerage to buy this kind of stock. Just be prepared that it may be a little more difficult to find the preferred stock that you want, as it’s far less commonly traded than common stock.
When you have done your research and decided which preferred stock you’d like to invest in, ensure that you’re making the trade using the correct ticker symbol. It may be easy to mistake the symbols for preferred and common stock for a given company and buy shares of the wrong thing accidentally.
Once you’ve got your preferred stock in your portfolio, you can anticipate starting to receive dividend payments. You may see some other limited amount of profit from appreciation.
How to choose common vs. preferred stock
Knowing whether to invest in common stock or preferred stock requires establishing a sense of your priorities for your investments.
The main question to ask yourself is: Are you interested in a bit less risk and regular income from your investments, or whether you’d prefer the potential for more profit but greater risk. The answer to that question is highly personal, depending on your age, financial situation, comfort with risk, and other factors.
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