Whenever we talk about investment, the first thing that comes to mind is stocks. It is also one of the most typical investment vehicles issued by public companies. There are two major types of stocks- common and preferred. When we talk about investing, we usually refer to common stock.
In this guide, we dive deep into common stock and how it differs from preferred stock.
What Is A Common Stock?
When public companies need money, they issue shares known as common stocks. Private and institutional investors invest in common stocks. As a stockholder, you become a shareholder in the company, which bestows you with certain rights.
Common Stock vs Preferred Stock
As explained above, a stock represents ownership in a company. Common stock and preferred stock have varying rights. As the name suggests, preferred shareholders enjoy a preference over common shareholders. They have a higher claim on assets at the time of liquidation, the dividend is usually fixed and is paid before any dividend is distributed to common shareholders and preferred shareholders can convert their shares into common stock. However, they do not have voting rights in the company.
In contrast, common shareholders have voting rights, but their dividends aren’t guaranteed and they are last in line to claim any assets in case of liquidation. Common stock cannot be converted into any other form of security.
Advantages of Investing in Common Stocks
Besides the quick transaction process, common stocks offer several benefits to shareholders.
Potential for High Returns
One of the biggest reasons to invest in the stock market is the potential to make high returns. Stocks have the possibility of growing in value over time, generating capital appreciation for investors. When you sell the stock at a higher rate than you bought it for, you make a profit. Say, you buy Apple stock for $150 and sell it when the stock reaches $200. You make a profit of $50 on the stock. Historically, stocks have shown better performance in comparison to other types of investment products like bonds or savings accounts.
Dividends
Another way to make money through stocks is via dividends. Companies often distribute a part of the profit to the shareholders in the form of dividends. By reinvesting these dividends, you can enjoy higher returns due to the compounding effect.
Ownership and Voting Rights
Common shareholders own a part of the company, which gives them voting rights on corporate issues, thus affecting company decisions.
Liquidity
Common stocks can be easily purchased and sold on exchanges. They are easy to trade and offer quick liquidity when required.
Diversification Opportunities
Investing in stocks can help with portfolio diversification. By spreading funds across different sectors, industries and companies, investors reduce risk.
Risks and Considerations with Common Stocks
No investment is immune to risk and common stocks are no exception. Here are some factors to keep in mind before investing.
Market Volatility
Market volatility is a part and parcel of the stock exchange. Stocks will see price fluctuations caused due to market volatility. There are several factors outside of the control of an investor, which could result in losses. These include geopolitical events, company results, investor sentiment and the economy.
Company-Specific Risks
Individual stocks come with company-specific risks like operational issues, supply chain concerns, management choices or a shift in the industry. Such events can have a negative impact on the stock price.
Long-Term Investment Horizon
Investing in common stocks with the intention to make quick profits can be risky. It could take some time for the price to rise after falling. This is why it is advisable for investors to adopt a long-term approach when it comes to investing. Building wealth through stock investment is possible, but it will not happen overnight. Holding the stocks through market fluctuations and uncertainty can increase the chances of higher returns.
Dividends and Payout Risks
Companies do pay dividends, but there is no guarantee. Some pause dividends, while others lower the dividends during periods of financial struggle or economic challenges. This can affect the income of investors who depend on dividends for steady cash flow.
Factors Affecting Common Stock Prices
Several factors come into play in the rise and fall of stocks. Here are a few of the most important.
Company Performance
The biggest and most obvious factor behind the stock pricing is how well the company is faring. If the company is reporting steady income growth, high profits and free cash flow, the stock price is likely to remain steady in the long term. However, if the company is struggling financially, the stock will remain flat or drop.
Market Conditions
Stock prices see fluctuations in the shape of the general market. In a period of recession when investors pull back, the share prices drop. On the other hand, in an economic boom, there will be higher trading volume and the prices will rise. Even specific stock sectors have their own boom-and-bust periods, affecting the stock prices.
Economic Indicators
The measurement of global and national economies impacts stock pricing. The gross domestic product (GDP) metric shows the value of the goods and services in a country. Other than that, interest rates, inflation, unemployment and the Consumer Confidence Index also play a role in the market's ups and downs. However, these tend to have a temporary impact.
Company News and Events
Individual companies are affected by the news specific to them and the management is usually prepared for it. When Satya Nadella took over as Microsoft’s CEO, the share price increased and when Steve Jobs first resigned from Apple, the shares dropped. With major company events or news, stock prices undergo transformation.
Supply and Demand Dynamics in Determining Stock Prices
Investor sentiment can bring about major ups and downs in stock prices. If investors have a positive sentiment and are enthusiastic about a company, the demand for its shares will be higher than the supply and this could take prices higher. On the other hand, if investors do not have any interest in a company, the shares will not be in demand and the prices will drop.
How To Invest In Common Stocks
Stocks can be considered an important part of any portfolio today. While they carry a higher risk than bonds or CDs, they also have a higher potential for returns. Historically, stocks have outperformed other investments in the long term. There are different kinds of stocks you can add to your portfolio. The two most common types are growth stocks and value stocks.
Growth stocks are those stocks that experience a rise in earnings and the share prices increase. On the other hand, value stocks have a lower price relative to the fundamentals and they usually pay dividends, unlike the growth stocks. Growth stocks are much riskier.
Stocks can also be classified by the market capitalization. They are divided into large-cap, mid-cap and small-cap categories. Large-cap stocks are stable, well-established companies and often the hot picks. In contrast, small-cap stocks are new companies and tend to be volatile.
A diverse portfolio across different sectors and companies can reduce the chances of a loss. If one sector is down, there are others that can make up the difference. That said, buying and holding stocks for years can generate steady income and capital appreciation. Solid, long-term stocks can become the backbone of your portfolio.
Frequently Asked Questions
Can a company have more than one type of common stock?
The two most common types of stocks are common and preferred. However, companies can issue different classes of common stock. Google’s parent company Alphabet has two classes of common stock: GOOG and GOOGL.
Which is a better investment: Preferred or common stock?
Investing comes with its set of advantages and drawbacks. Common stock has high volatility but also offers higher potential returns. On the other hand, preferred stocks are less volatile but have a lower potential for returns. If you can handle volatility, common stock can be a good choice, but if you want to play safe and avoid fluctuations, choose preferred stock.
What are Class A and Class B shares?
Class A and Class B are different types of shares issued by a company. They have varying characteristics and voting rights. Class A offers one vote per share and is widely available to the public. On the other hand, Class B has multiple votes per share and is held by senior management or investors.
About AJ Fabino
AJ Fabino is the Investing & Cryptocurrency Editor at Benzinga, overseeing a range of financial content, including stocks, ETFs, options, mutual funds, futures, IPOs, bonds, and cryptocurrency. With extensive experience in financial journalism and content strategy, AJ is dedicated to delivering engaging, insightful, and timely news that empowers readers to make informed investment decisions.
