Last updated on July 31st, 2019 at 10:10 am.
Did you know there are actually two types of stock? There is common stock – the type most of us know. Then there is the less-talked-about preferred stock.
So, what is preferred stock? This is another type of security along with common stocks and bonds. This type of stock is sort of halfway in between the two. It shares some of the advantages – and disadvantages – of both.
Preferred Stock Pros
Institutional investors buy the majority of this type of stock. That is in large part because they can exclude 70% of dividends from their taxable income. Despite this advantage, it is also available to individual investors.
One of the biggest pros for preferred stock is exactly what its name implies. When dividends are paid out, these shares are given preference over common stock.
If a company experiences financial hardship, preferred stock has priority over common stock. This can be beneficial in the event of a liquidation. They don’t take precedence over bonds in this case, however.
Another benefit is that these shares can be converted to common stock. The reason this a benefit is that common stock can’t be converted to preferred stock.
In some cases, if a company has to stop issuing dividends, they must pay all dividends owed to preferred shareholders before they can pay dividends to common shareholders. This is what’s known as cumulative preferred.
Note that not all preferred shared work this way; they can also be non-cumulative.
Preferred Stock Cons
Although preferred stock has some features that could make them attractive, they also have drawbacks. These drawbacks are arguably what make them less common than common stock and bonds.
Despite taking precedence over common stock with respect to dividend payouts, preferred stock carries no voting rights. This means that shareholders will be unable to partake in the decision-making process.
Another drawback of preferred shares is their limited growth potential. This is another way in which they are similar to bonds. Though their price will be more stable than that of common stock, it also won’t increase as much as the company grows.
Common Stock Benefits
Arguably the most attractive quality of common stock is its growth potential.
Just as the lack of voting rights is a con for preferred, common stock does have this right. Many individual investors may never exercise this right, but it’s a benefit for common stock, at least in theory.
This is the easiest way for the average investor to get started. As such, it makes sense that they’re the most popular.
Common Stock Drawbacks
Yet again, many of the drawbacks for common shares are also benefits of preferred shares.
Although growth potential is greater for them, they can also fall further during a market correction. Common stock value can be difficult to predict, but that is part of the risk that allows them greater reward potential.
They will also be last in line to receive dividends.
Callability and Interest Rates
One “feature” of preferred stock is that they may be callable. This means they can be purchased by the issuer and par value before their end date.
The issuer can then issue new shares with a lower yield. These shares are not always callable, but it’s something the investor must keep in mind.
In addition, when interest rates fall, preferred stock goes up in value. The opposite is also true. This is different from common stock, where value is determined by the market. That could make preferred shares better in a declining market.
As you can see, it makes sense in a way that these preferred shares are less common than other securities. They are less volatile than common stock but have less growth potential.
At the same time, they’re more stable like bonds but have lower seniority.
Should You Buy Preferred Stock?
For the individual investor, common stock is generally better. The reason for this is they have better growth potential. Thus, someone who is looking to accumulate wealth would turn to this option.
At the same time, one looking to reduce their risk can simply add bonds to their portfolio.
Unless the individual investor relying on dividend income, it probably makes more sense stick to the more typical common stock.
Nevertheless, it’s good to be aware of the differences between them.