Did you know that more than one type of stock is available for purchase on the market? Preferred stock is a combination of stock and bond and entitles its owner to a number of benefits over an owner of common stock.
Though you can purchase preferred stock similar to how you’d purchase common stock, owners of preferred stock should have a better understanding of investment risk and pay closer attention to stock performance.
What Are Preferred Stocks?
Preferred stock is a type of stock that gives investors a fixed dividend and priority over common stockholders when it comes to the payment of dividends or liquidation of assets in the event the company goes bankrupt. Preferred stock usually has a fixed dividend rate, meaning that it pays out a predetermined amount each quarter or year. The rate is often higher than what common stocks offer, making them an attractive option for investors looking for steady income.
Steps for Purchasing Preferred Stocks
Believe that preferred stock is the right choice for you? Follow these steps to add preferred stock to your list of assets.
Compare the Credit Ratings of Preferred Stock of Different Companies
Like bonds, preferred stocks carry a credit rating that you can see before you decide to buy. Preferred stocks with a higher credit rating will carry less risk than those with lower ratings. To check the credit ratings of your preferred stock, visit Standard & Poor’s global site, create an account and search for a company using the “Find a Rating” tab.
Compare Online Brokerage Firms and Open an Account
Like buying common stock, purchasing preferred stock requires you to deal through a broker or brokerage firm. Many brokerage firms operate online, allowing you to open an account with a low minimum balance and trade. Brokers have unique advantages and disadvantages.
Consider a number of factors, including trading support, commissions, fees, ease of platform use and brand reputation before opening an account. Not sure where to start? Check out Benzinga’s list of the best online brokerage firms for a crash course in choosing a broker.
Decide How Many Shares You Want to Purchase
Follow your stock of choice for at least a week before you make sure you’re buying at a low price. A common mistake that beginners make when executing their first trade is to buy too much in an effort to lower the effects of their broker’s commission.
A better strategy is to be conservative, buy a few shares and see how they do in the coming weeks. Consider purchasing more if they perform well. If the value of the preferred stock drastically drops, you can change your mind about buying more.
Place Your Order With Your Broker
Once you’ve decided how many shares you’d like to buy, use your brokerage’s trading platform to request a buy. Though the specific mechanisms of how to execute your trade will depend on your platform, most brokerage firms have a specific tab or page dedicated solely to buying and selling stock.
Enter the name of the stock, your order type and the number of stocks you’d like to buy. Your broker will handle the rest, and you’ll soon see your new stocks in your account.
Monitor Your Stock’s Performance
Preferred stock is a more stable investment than common stock. However, you should make time to evaluate your stock’s performance at least once a year and recalibrate your portfolio to remove underperforming assets.
Pros of Preferred Stocks
- Regular Dividend Payments: Preferred stocks typically offer fixed dividend payments to shareholders. These dividends are usually higher than those of common stocks and are paid out before dividends are distributed to common stockholders. This provides investors with a consistent income stream.
- Priority in Asset Distribution: In the event of liquidation or bankruptcy, preferred stockholders have priority over common stockholders in receiving their share of the company's assets. This means that preferred stockholders are more likely to recoup their investment compared to common stockholders.
- Less Volatility: Preferred stocks are generally less volatile than common stocks. They tend to have a more stable price and are less influenced by market fluctuations. This can be attractive to investors who are looking for a more predictable and steady investment.
- Potential for Capital Appreciation: While preferred stocks are generally considered income-oriented investments, they can also offer the potential for capital appreciation. If interest rates decrease or the company's financial performance improves, the market value of preferred stocks may increase, allowing investors to sell their shares for a profit.
- Convertibility Options: Some preferred stocks have the option to be converted into common stock at a predetermined conversion ratio. This can provide investors with the opportunity to benefit from any future growth in the company's common stock price.
- Lower Risk Than Bonds: Preferred stocks are considered hybrid securities because they have characteristics of both stocks and bonds. While they offer higher yields than bonds, they also have the potential for capital appreciation. This makes them a potentially attractive option for investors who are looking for a balance between income and growth.
- Tax Advantages: In some jurisdictions, preferred stock dividends may be taxed at a lower rate than interest income from bonds. This can provide investors with a tax advantage and increase their after-tax returns.
- Diversification: Adding preferred stocks to an investment portfolio can help diversify risk. By including different types of securities, such as stocks, bonds, and preferred stocks, investors can spread their risk across various asset classes and potentially reduce the overall volatility of their portfolio.
Cons of Preferred Stocks
- Limited voting rights: Preferred stockholders usually have limited or no voting rights in the company. This means that they have little or no say in the decision-making process and corporate governance.
- Lower potential for capital appreciation: Preferred stocks typically have a fixed dividend rate, so their price appreciation potential is limited compared to common stocks. Investors looking for significant capital gains may find preferred stocks less attractive.
- Interest rate risk: Preferred stocks are sensitive to changes in interest rates. When interest rates rise, the value of preferred stocks may decline, as investors may seek higher-yielding investments elsewhere.
- Subordination to debt holders: In the event of bankruptcy or liquidation, preferred stockholders are typically paid after debt holders but before common stockholders. This means that if a company faces financial difficulties, preferred stockholders may not receive their full investment back.
- Lack of dividend stability: While preferred stocks offer fixed dividends, companies have the option to defer or suspend dividend payments if they face financial challenges. This can lead to uncertainty and potentially lower income for preferred stockholders.
- Limited participation in company growth: Preferred stockholders do not benefit from the same potential for growth as common stockholders. If a company experiences significant growth, preferred stockholders do not typically participate in the increased value of the company.
- Lower liquidity: Preferred stocks often have lower trading volumes compared to common stocks, making them less liquid. This can make it more challenging for investors to buy or sell preferred stocks at their desired prices.
- Potential call risk: Some preferred stocks may have call provisions, allowing the issuer to redeem the shares before their maturity date. If a company decides to call the preferred stock, investors may have to reinvest their funds at potentially lower yields or prices.
- Lack of ownership rights: Preferred stockholders do not have the same ownership rights as common stockholders. They may not have the ability to attend shareholder meetings or have a say in major company decisions.
- Limited upside potential: Preferred stocks typically have a fixed dividend rate, so investors may not benefit from increased dividend payments if the company's financial performance improves. This can limit the potential for higher returns compared to common stocks.
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The Difference Between Preferred Stock vs. Common Stock
Common stock and preferred stock are similar in a number of ways — they both entitle the holder to a percentage ownership of the company, they’re both bought and sold on the open market and the process for acquiring both types of stock is similar. Despite these similarities, the differences between each type of stock are as follows.
As its name suggests, common stock is usually the type of stock you purchase when trading unless otherwise specified. Owners of common stock make the most money when they sell their holdings.
The value of common stock fluctuates with the movement of the market, so common stockholders aim to buy their stocks at a low price and sell when the value increases. Common stock is considered more risky than preferred stock because it is volatile and not guaranteed to return dividend payments.
Preferred stock carries less risk than common stock because it receives higher and more frequent dividend payments. Unlike common stockholders, preferred stockholders receive fixed stock dividends on a predetermined schedule. These dividends are not subject to the ebb and flow of the general market.
If a company declares bankruptcy, preferred stockholders receive payouts before common stockholders. However, preferred stock may be callable, meaning that the company can purchase the stock back at any time, for any reason.
Though preferred stock may be less volatile, it means that it has a lower potential for profit. Preferred stock options are usually a better idea for investors closer to retirement or those with a lower risk tolerance. Watch the video below for more detail.
Stable Investment Option
Buying preferred stock offers a stable investment with stock and bond benefits. Investors should compare credit ratings, select a reputable brokerage firm and decide on the number of shares to purchase. They should then place an order and monitor the stock's performance for consistent dividend yields and lower volatility. Preferred stock is a good option for stability and reliable returns.
Check Out Preferred Stocks
Common stock has a higher potential to increase drastically in value, but it can also lose its value in an instant. Check out preferred stocks or purchase bonds to hedge your risk.
Near retirement? Don't want to risk your savings? Preferred stocks are less volatile and can retain value to provide more security as you invest.
Ready to start investing in preferred stock? Check out Benzinga's guide on how to create an investing strategy.
Frequently Asked Questions
What is a preferred dividend?
A preferred dividend is one that is accrued and paid on a company’s preferred shares. In the event that a company is unable to pay all the dividends, preferred dividends are paid first over dividends that are paid on common shares. Preferred stock pays higher dividend rates than common stock of the same company — it’s the main benefit to owning preferred shares.
How do preferred stocks trade compared to common stocks?
Preferred stock trades the same way as common stock — it usually occurs through a brokerage firm and with the same transaction costs.
Common and preferred stock prices offered by the same company differ. Preferred stock tends to be more stable because of their regular income stream, and common stock is often more volatile.
What are the different types of preferred stock?
The classes of preferred stock include cumulative, convertible, callable and participating.
What are the features of preferred stock?
Preferred stock has several components, including preferences in dividends, liquidation, non-voting, callable and convertible options.