When investing in the stock market, you may come across two main types of stock: common stock and preferred stock. Both represent ownership in a company, but they come with different rights, benefits, and risks. Understanding the difference between common and preferred stocks is crucial for building a diversified portfolio that matches your financial goals.
What is Common Stock?
Common stock is the most widespread type of stock that investors buy. When you purchase common stock, you become a partial owner of the company and gain certain rights, such as voting on corporate matters and receiving dividends (if the company chooses to distribute them).
1. Voting Rights: Common shareholders typically have the right to vote at shareholder meetings. They can vote on important issues like the election of the board of directors and major corporate policies. This gives investors a say in the company’s direction.
2. Dividends: While common stockholders may receive dividends, they are not guaranteed. Dividends are usually paid from company profits, and the amount or frequency can vary depending on the company’s financial performance.
3. Capital Appreciation: The value of common stock is tied to the performance of the company. If the company grows and becomes more profitable, the stock price usually increases, giving shareholders the opportunity for capital gains when they sell their shares.
4. Higher Risk: Common stock comes with more risk compared to preferred stock. In the event of bankruptcy, common shareholders are paid after creditors, bondholders, and preferred stockholders, meaning they are more likely to lose their investment if the company fails.
What is Preferred Stock?
Preferred stock offers certain advantages over common stock, including fixed dividends and priority in asset distribution. However, preferred shareholders usually do not have voting rights.
1. Fixed Dividends: Preferred stockholders receive fixed dividends, which means they are paid a set amount on a regular basis, regardless of the company’s profits. This makes preferred stock a more stable income-generating investment compared to common stock.
2. Priority in Payouts: In the event of a company’s liquidation or bankruptcy, preferred shareholders are paid before common shareholders. This priority reduces the risk of losing their investment, although it still comes with some risk compared to bonds.
3. No Voting Rights: Unlike common stockholders, preferred shareholders typically do not have voting rights in the company. They do not participate in decisions such as electing the board of directors or approving mergers.
4. Convertible Feature: Some preferred stocks are convertible, meaning they can be exchanged for a certain number of common shares at a predetermined price. This feature allows investors to benefit from capital appreciation if the company’s stock price rises.
Key Differences Between Common and Preferred Stock
1. Dividends:
• Common Stock: Dividends are variable and not guaranteed. Companies may choose to reinvest profits instead of paying dividends.
• Preferred Stock: Dividends are fixed and paid out regularly, offering a more reliable income stream for investors.
2. Voting Rights:
• Common Stock: Common shareholders typically have voting rights and can influence company decisions.
• Preferred Stock: Preferred shareholders usually do not have voting rights.
3. Risk and Reward:
• Common Stock: Higher risk but offers the potential for higher returns through capital gains.
• Preferred Stock: Lower risk due to fixed dividends and priority in asset distribution, but generally offers less potential for capital appreciation.
4. Priority in Bankruptcy:
• Common Stock: Paid last in the event of liquidation, after creditors, bondholders, and preferred shareholders.
• Preferred Stock: Paid before common stockholders but after debt holders.
Which Type of Stock Should You Choose?
• Common Stock: Ideal for investors looking for long-term growth potential and who are willing to accept higher risk in exchange for higher returns. Common stocks are more volatile but offer greater opportunities for capital appreciation.
• Preferred Stock: Best suited for income-focused investors who prioritize regular dividend payments and want more security in their investments. Preferred stocks provide stability, but with limited upside potential compared to common stocks.
Conclusion
Both common and preferred stocks have their place in an investment portfolio, depending on your financial goals and risk tolerance. Common stock offers the potential for greater returns but comes with more risk, while preferred stock provides more stability with regular income through fixed dividends. By understanding the differences between these two types of stock, investors can make more informed decisions to balance growth and income in their portfolios.
