Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It may not have not been reviewed, commissioned or otherwise endorsed by any of our network partners or the Investment company.
Updated on Friday, January 11, 2019
Investing is one of the best ways to grow your nest egg — and one of the only ways to make more money without logging extra hours at work.
But it also can be pretty confusing. Once you figure out what the stock market is and how it works, you still have to learn about the different types of assets out there. You’ll also want to do your research before you make any purchases.
Even if you feel fairly confident about investing in stocks, you may not realize that these basic securities actually come in two different flavors: common and preferred.
So what is preferred stock, and why would you consider investing in it? Read on to learn more about this unique asset category and the benefits that make it attractive to some investors.
Preferred stock vs. common stock
In many ways, preferred stock and common stock are the same. In both cases, you purchase a small “share” of ownership in the company, which has the potential to create profit based on the success of the enterprise.
But as the name suggests, preferred stock owners enjoy preferential treatment in some regards. Although they may not be eligible to vote on shareholder issues like those who own common stock, they’re paid fixed dividends on a regular basis — and they’re paid immediately after bonds but before common stock.
That means buying preferred stock puts you at a lower level of risk since your dividends outrank common shareholders’ if the company should fail or endure major losses. Of course, that pendulum swings in both directions: Since the dividends on preferred stocks don’t fluctuate with the company’s market value, you may miss out on higher earnings if the company should see a sweeping success.
You can think about it as a kind of hybrid between common stock — which is the stock you’re probably thinking about when you talk about the market — and fixed-interest securities like bonds. Preferred stock offers a way to invest in equity that provides some of the same security as other fixed-interest securities. However, preferred stocks generally offer higher growth potential than bonds do, and in many cases, they can be held indefinitely (as opposed to the predefined, shorter-term lifespans of most bonds).
|Common Stock||Preferred Stock|
|Dividend Payout||Decided by board||Paid at regular intervals|
|Dividend Amount||Determined by profitability of company/market performance||Fixed dividend amount that may respond to changes in interest rate|
|Voting Privileges for Shareholders||Likely||Unlikely or reduced|
|Callability (Issuer Can Recall)||No||Yes|
|Riskiness||Moderate to high||Higher than bonds but lower than common stock|
|Growth Potential||High||Higher than bonds but potentially lower than common stock|
Pros and cons of preferred stock
Like any other prospective investment, preferred stock comes with both benefits and drawbacks to consider before you add it to your portfolio.
Benefits of preferred stock
- Predictability. Preferred stock is paid on a regular basis and often at a fixed dividend rate, which means you’ll have a better idea of what to expect as far as returns are concerned than you might with common stock.
- Less vulnerability to market volatility. Although preferred stocks’ fixed dividend rates can respond to changing interest levels, these securities have a face value, sometimes known as a “par value,” like bonds. Unlike common stocks, their worth is not determined by market fluctuations.
- More security in the case of insolvency. Because preferred stock dividends are paid before those of common stocks, you’ll be in a better position to recoup your losses should the company you’re investing in fail.
Drawbacks of preferred stock
- Reduced or nonexistent voting rights. Unlike common stocks, preferred stocks may not come with voting rights for shareholders — or may confer only reduced voting privileges.
- Less exponential growth potential. Although you generally know what you’re getting in return for your investment in preferred stock, your growth potential usually is capped at the predefined dividend payout. In the case of an outstanding success, you might have earned more if you’d purchased common stock.
- In many cases, the issuer has the right to recall or redeem preferred stock at a preset price after a certain amount of time. This is known as “callability” and can create unexpected shifts in your long-term investing strategy.
When is preferred stock advantageous?
As you can see, preferred stock inhabits a bit of a gray area. It’s usually not considered as safe as a bond and doesn’t offer quite as much earning potential as common stock.
So when is it a good idea to choose this hybrid option?
- Investing in preferred stock might be a good option for those who have a low risk tolerance but still would like to see greater returns than those available through bonds.
- Preferred stock can create a source of steady income, which can be attractive to investors with higher cash-flow needs or a shorter investment horizon.
- Preferred stock can add another layer of diversification to your portfolio, which can help your investments withstand market fluctuations and dips.
However, it’s important to keep in mind that it is a more advanced sort of investment than common stock or even bonds — which is why it’s purchased less frequently than common stock, said Malik S. Lee, certified financial planner at Felton & Peel Wealth Management.
Although the differences we’ve outlined above hold true generally, preferred stocks vary considerably in their individual features, which means it’s extra important to do your research before you make an investment. For example, not all preferred stocks are callable, but some are; dividends might be cumulative (i.e. stackable if one is deferred) or noncumulative.
In short, “they’re complicated,” as Lee put it. “Each preferred stock will have different characteristics to it. You’ve really got to dive into the prospectus and look into what you’re buying.”
Should you invest in preferred stock?
Ultimately, the only person who can decide if preferred stocks are right for your investment portfolio is you. (Although talking with a qualified financial advisor probably wouldn’t hurt, either.)
If you do decide to invest in preferred stocks, you’ll purchase them the same way you would common stocks or other securities: through a brokerage firm, which may levy certain trading and commissions costs at the time of purchase. To learn how to get started, check out our step-by-step guide to investing for beginners.