The myth
Preferred stocks appeal to investors who want to earn regular dividends from their stock investments.
Preferreds are seen as a hybrid between a stock (due to its capital appreciation potential) and bonds (due to its regular stream of income by way of dividends, instead of coupons).
Given the name and unique features, preferred stocks may leave the impression that they’re a special type of investment vehicle that ranks above common stocks.
The reality
When you own preferred stocks, you have priority (termed as “preference”) over common stockholders in terms of dividend payments and asset distribution. This is what the name “preferred” refers to.
Put simply, preferred shareholders are paid first before common shareholders. Dividend payments for preferred shareholders also tend to be higher and more consistent than those common shareholders may receive.
Some preferred shares even offer “cumulative” payments. If a company runs into trouble and can’t pay dividends during a certain period, the payment amount will roll over to the next period.
Unpaid dividends will keep adding up until the company is able to pay. When the company recovers, preferred shareholders are ahead of common shareholders in the order of payment.
The priority status of preferred shareholders also applies if a company goes bankrupt. The liquidated assets will be used to pay creditors (such as bondholders) first, followed by preferred shareholders. Common stockholders are paid last.
Though the offer of fixed payments and relative safety can be attractive, investing in preferred stocks may also come with disadvantages.
Firstly, preferred shares may be redeemable. This feature gives the issuing company the right to buy back these shares, even if you aren't willing to sell.
If a company exercises this right, you’ll no longer be entitled to future dividend payments.
It’s also generally easier to buy and sell common stocks since they’re traded more frequently and at a larger volume. In contrast, preferred shares are less frequently traded, which can make them harder to purchase and resell.
Additionally, common stocks tend to see more price swings. The higher volatility means they have a better potential to grow, though the risk of loss is also greater.
Prices of preferred shares are usually more stable – which can be a good thing if you want security – but the low volatility also limits their growth potential.
If you care about having a say in company matters, keep in mind that preferred shares may not grant you voting rights like common stocks usually do.
Given the pros and cons of each type, the better choice will ultimately depend on your situation and what you need from your investments.
Preferred stocks can be ideal for investors who are focusing on income and seek relative stability. Common stocks may suit you if you’re looking for long-term growth and can handle the associated risk.
Verdict: It depends.
One type of stock isn’t necessarily better than the other. Each offers unique features, and it’s up to you to check which type is a better fit for your portfolio.
You can even have a mix of different types of stocks if they suit your risk tolerance and goals. Doing so can also help you diversify against risk.
