There are different types of stocks. Two of which are categorized based on rights and privileges: common stock and preferred stock. Both are equity instruments issued by companies. Purchasing and owning either one of them represent a portion of ownership of the issuing company.
But there are notable distinctions between the two. This article defines the difference between common stock and preferred stock while weighing which between the two is the better option when it comes to investing in stocks.
What is the Difference Between Common Stocks and Preferred Stock? Which One is Better?
Defining Common Stock and Preferred Stock
Remember that both common stock and preferred stock are two types of stocks or equities based on rights and privileges. Common stocks represent ownership in a particular company, as well as residual claim to its current and future profits.
On the other hand, preferred stocks also represent ownership albeit limited stake in a company, in addition to preferential treatment over the distribution of profits and claim on assets in the event of liquidation or company dissolution.
It is also important to highlight the fact that common stocks are the most straightforward form of ownership. Preferred stocks, meanwhile, have characteristics of both common stocks and bonds, thus making them more appealing to certain investors.
The following are key characteristics that highlight further the differences between common stock and preferred stock:
• Rights: A common stock grants its holders the right to elect the board of directors of the issuing company and vote on corporate policies. However, in a liquidation, common stockholders are paid last after creditors, bondholders, and preferred stockholders.
Holders of preferred stocks have limited or no voting rights but have a higher claim on distributions than common stockholders. Furthermore, in a liquidation, these investors are paid first before holders of common stocks.
• Earnings: Investors can earn from stocks through capital appreciation and dividends. Common stocks have demonstrated better long-term capital appreciation than preferred stocks and bonds. Holders may be entitled to dividends as well.
However, because preferred stockholders have a higher claim on distributions, preferred stocks are also called dividend-earning stocks. These investors can also grow their wealth or the value of their investments through capital appreciation.
What makes preferred stocks more appealing to some investors is that they also act as bonds with a set dividend and redemption price. The dividends are guaranteed. Common stock dividends are less guaranteed.
• Risks: It is important to highlight the fact that common stocks have more potential for better capital appreciation than preferred stocks. Of course, in considering the risk-return tradeoff, high potential returns come with higher potential risks.
Common stocks fundamentally carry more risks because their value can fall to zero, especially if the issuing company becomes insolvent. Its price is more volatile or experiences more dramatic movements than preferred stocks.
Of course, preferred stocks have risks and their value can also fall to zero during extreme market conditions. It is still worth mentioning that preferred stockholders of established companies enjoy a passive income stream through regular dividends.
• Availability: Common stocks usually have one class. Some companies issue more classes if there is a need for special voting rights. Preferred stocks have multiple classes and there is no limit on how many a company can issue.
Note that preferred stocks have a redemption value that technically limits how much investors are willing to pay. Some companies also issue convertible proffered stocks that can be converted to common stocks under certain circumstances.
Choosing Between Common and Preferred Stocks
Both common stocks and preferred stocks have their respective advantages and disadvantages. Choosing between the two still depends on the risk profile of a particular investor, as well as his or her financial goals and objectives.
However, for individuals who are into passive investing and long-term buy-and-hold investment strategy, common stocks might be ideal because they have a better potential for better long-term capital appreciation than preferred stocks.
The most attractive advantage of common stock is that its value can dramatically grow over the years as the issuing company grows bigger and become more profitable and valuable. This type of stock is ideal for long-term growth investors.
Preferred stocks are ideal for individuals who want to receive a passive stream of income or those looking for investments similar to fixed-income securities such as bonds with relatively lower risk profile than common stocks.
The notable advantage of preferred stock is that it provides a higher dividend yield than the yield from bonds and dividend yield from common stocks. This type of stock is suitable for so-called high-yield income-seeking investors.
It is still important to remember that investing in stocks have overall advantages and disadvantages, including notable risks, especially when compared to the risks of investing in bonds, as well as other assets, securities, or investment options.