All investing involves some risk, and as the old saying goes, the higher the risk the greater the reward. When it comes to determining whether you want to invest your money in common stock or preferred stock, you should consider the level of risk you are willing to take. Preferred stock typically involves less risk than common stock, but this limited risk also limits the potential rewards.
All stock, whether common or preferred, represents ownership in a company. Each share of stock represents a proportionate share of ownership. This means if a company issues 100,000 shares of stock, and you own 1,000 shares, you own 1 percent of the company and are entitled to participate in the 1 percent of the company's profits and losses.
Dividends represent profits paid to shareholders. The company's board of directors is responsible for determining whether the company will pay a dividend to common stock holders and the amount of the dividend. These dividends, if declared by the board of directors, are typically paid on a quarterly basis. Preferred stock usually comes with a fixed dividend attached. This means the company will pay a fixed dividend, usually stated as a percentage of the preferred stock's issue price, to preferred stock holders each quarter, regardless of the profitability of the company, and whether common stock holders are paid a dividend or not. The dividend on preferred stock may be suspended by the board of directors, but only if they cut the common stock dividend first.
Preferred stock involves less risk than common stock because it is typically issued at the liquidation value of the company and pays a fixed dividend rate. Once issued, the market price of preferred stock tends to move in tandem with prevailing interest rates rather than on outside factors that commonly affect the price of common stock. In the event of a company liquidation, preferred stock holders receive preferential treatment in the distribution of assets. Bondholders would be paid first, preferred stock holders would be paid next and any assets remaining would be divided among the common stock holders.
Common Stock Advantages
Preferred stock can be a good option for investors interested in a steady stream of predictable income, but who also prefer to own equity investments rather than debt investments, such as bonds. The potential for capital appreciate is limited on preferred stock due to the fixed dividend rate and the liquidation valuation used to originally price the stock, but capital appreciation is possible on the open market. Common stock has unlimited capital appreciation potential. It also has the potential for increased dividend payouts, while the dividend rate on preferred stock is fixed. Common stock holders typically have the right to vote on the company's board of directors at a rate of one vote per share. Preferred stock usually does not provide shareholders with voting rights.
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