Understanding the differences between different stock types is a crucial component of your investing foundation.
Different types of stocks
Perhaps the most common types of stocks are preferred stock and common stock. The vast majority of regular, everyday investors (i.e. not Warren Buffet) purchase common stock. There are a few scenarios where it makes sense to invest in preferred, stock but it’s not a common scenario (no pun intended.)
In a nutshell, common stock and preferred stock have a few main differences. Namely, the differences are in voting rights, how income is generated, and priority when it comes to claims on company assets and income in the case of insolvency.
Common stock explained
Common stock means that you have equity (ownership) in a company along with voting rights. This means that as a company makes money and the market value of the stock appreciates, a common stock owner will reap the benefits of that appreciation upon selling the stock at a higher price. Also, the ability to vote on important company issues are extended to common stock owners.
In some cases, there are companies that elect to pay dividends to its common stock shareholders. When added to the potential appreciation of a stock price, regular, recurring dividend income can be an additional perk of owning common stock. However, but not every company pays dividends on its common stock offerings.
For some investors, dividend income is a crucial part of their investment strategy. But since common stock doesn’t always offer this benefit, they may look to purchasing preferred stock instead.
Different classes of common stock shares
It’s also worth noting that companies may also have different classes of common stock shares. Often, these different classes will have a separate ticker symbol to distinguish between the separate classes. For example, Twenty-First Century Fox, Inc. has two classes of shares. Class A common stock uses the ticker symbol is FOXA while the class B voting shares uses the symbol FOX.
The different classes of shares usually come down to the difference in voting rights associated with each share class. In some cases, one class may have 5 votes per share while another has only one vote per share. In some cases, voting shares may be much more expensive than non-voting shares.
Preferred stock explained
Like common stock, preferred stock also represents ownership in a company although preferred shareholders don’t have voting rights. Many investors like preferred stock because of the regular dividend payments associated with this type of stock.
To understand preferred stock a little better, it helps to know how bonds work. Bonds are an investment type that represents a loan to an entity like a corporation. It means you are lending the company money that you expect to be repaid when the loan matures.
In addition to getting repaid on the maturity date, you can also get semi-annual payments according to the bond’s coupon rate. For example, a bond with a par value of $1,000 and a coupon rate of 2% will pay $20 a year until the maturity date.
The par value of the bond is not always the same price that the market sets for a bond. Like stocks, bonds can be traded in markets above or below their par value. Even if the market value of the bond changes, the coupon rate stays the same and the payout continues until the bond matures.
Essentially, investors like bonds because they represent predictable, annual income with a promise to repay the principal loan amount. They are often seen as less risky than stocks for this reason.
Though bonds are less risky, the downside is that a bondholder does not have an ownership stake in the company like a shareholder. If a company is doing well and the stock price goes up, a bondholder will not partake in the company’s success via stock appreciation.
An investment in preferred stock can combine the benefits of stock ownership, like appreciation, with the predictability of regular income with dividend payments. Interested in preferred stock? Here’s how it works.
Like bonds, preferred stock has a par value—typically $100 or $25. There’s no maturity date but there is a yield or effective interest rate that is expressed as a percentage of the par value. The yield represents the amount of income a preferred stockholder can expect as a dividend payment each year.
For example, preferred stock with a par value of $25 and a stated annual dividend of 10% would pay $2.50 per year. Unlike bonds, however, the par value is not a guarantee of repayment and can lose all of its value if a company cannot meet all of its financial obligations. Preferred stock is like a stock because the value of the shares can fluctuate above or below the initial purchase price.
You should also know that preferred stock owners do not have voting rights. They do, however, have priority over common stockholders when it comes to getting paid in case a company becomes insolvent or has to suspend dividend payments.
When it’s time to pay all stakeholders like lenders and investors, preferred stockholders have priority over common stock owners (but are subordinate to bondholders.) Preferred shareholders must also be paid before common stock shareholders when it comes to receiving dividend payments.
Lastly, it doesn’t hurt to know about convertible preferred stock. Convertible preferred stock can be converted into common stock shares. You have the option to convert your shares at will or the issuing company can force a conversion. When you convert your preferred stock, you are giving up your rights as a preferred stock shareholder.
Pros and Cons of each type of stock
The pros and cons of each type of stock will really just come down to your investing preference and how that aligns with your personal financial goals.
Pros of preferred stock
Regular, predictable, dividend payments
Prioritized repayment over common stock shareholders
Can benefit from stock appreciation
Cons of preferred stock
Low trading volume: Purchasing preferred stock is not very common. It could be difficult to buy and sell shares at times.
Subordination to bondholders: If a company experiences insolvency, bondholders are paid before preferred stockholders.
Rising interest rates: Can make preferred stock less attractive if better returns are available with other investments (i.e. common stock, bonds, etc.).
Possible suspension of dividend payments, which could occur if a company faces financial trouble.
Pros of common stock
Voting rights
Can benefit from stock appreciation
Cons of common stock
Taking losses when the value of a stock drops
Taking losses in the case of insolvency
Which kind of type of stock is right for me?
This will all depend on your tolerance for risk, preferred investing strategy and even the stage of life you are in. The important thing here is that you commit to investing and not get “analysis paralysis” trying to pick the perfect type of stock.
Remember, you can always get a combination of different stock types. You don’t have to pick one or the other if you’d like to try investing in both. If you are not happy with the type of stock you’ve invested in, you can always sell it and try again with another investment that suits your investing strategy better.
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