Preferred Stock vs Common Stock: A Complete Guide 2024

Deciding between preferred and common stock?

You’re not alone in weighing these two fundamental investment options that could significantly impact your portfolio’s performance.

While common stock might be what first comes to mind when you think of investing, preferred stock offers a unique set of advantages that could better align with your financial goals. From dividend priorities to voting rights, each type serves distinct purposes in the investment landscape.

Let’s dive into the key differences between these two stock classes and help you make an informed decision about which might be right for your investment strategy.

Key Differences Between Preferred and Common Stock

In my experience, distinguishing between preferred and common stock is essential, as each aligns with different investor goals and financial strategies.

Although both represent ownership in a company, preferred and common stocks offer unique features that can impact an investor’s approach to income and growth.

Common Stock is widely recognized and often thought of as the default type of stock ownership.

For investors, it offers potential for appreciation aligned with the company’s growth and success. Shareholders of common stock might receive dividends, though these vary based on the company’s earnings and policies. This flexibility allows common stockholders to benefit when the company prospers, with the potential for higher returns in the long term, but it also means greater exposure to market fluctuations.

Preferred Stock, on the other hand, is designed to provide stability and predictable returns.

Typically, preferred stockholders receive regular, fixed dividends, which are prioritized over any common stock dividends. This feature makes preferred stock appealing to those who seek steady income rather than variable returns. Preferred stockholders also hold a senior position in the event of liquidation, receiving compensation before common stockholders in financial distress scenarios.

Selecting between the two depends on balancing the desire for income stability against the opportunity for potential capital gains.

Voting Rights Comparison

Voting rights are a significant factor that differentiates common stock from preferred stock.

Common Stockholders typically enjoy voting rights, allowing them to have a say in corporate decisions.

This can include electing the board of directors and approving major corporate actions. For example, Apple (AAPL) stockholders use their voting power to influence the company’s policies and strategic direction. This voting power can be a critical tool for shareholders who want to ensure the company aligns with their values and expectations. In practice, we’ve found that common stockholders often leverage this influence to shape strategic decisions.

In contrast, Preferred Stockholders generally do not have voting rights.

This lack of influence is often offset by the financial benefits they receive, such as fixed dividends. For instance, in a company like Google, preferred stock might be issued without voting rights, focusing instead on providing a steady income stream. This makes preferred stock appealing to investors who prioritize income over corporate influence.

Dividend Payment Priority

Dividends are another area where common and preferred stocks differ significantly.

Common stock dividends are variable and depend on the company’s performance and dividend policy. This means that while common stockholders can potentially receive higher dividends during profitable times, there’s also a risk of reduced or eliminated dividends during economic downturns.

In contrast, preferred stock offers fixed dividends, which are paid out before any dividends are distributed to common stockholders. For example, a company might issue a 5% preferred stock with a $50 par value, ensuring a $2.50 annual dividend per share.

This prioritized payout order makes preferred stock attractive to those who seek regular dividends regardless of the company’s performance.

Risk-Return Profile and Market Trading Characteristics

Preferred and common stocks offer distinct profiles in both risk and market trading characteristics, aligning with different investor goals.

Common Stock offers growth potential, appealing to investors comfortable with higher risk for the chance of higher returns. Common stocks are typically more volatile and widely traded, meaning their prices fluctuate more based on market sentiment, company performance, and economic conditions.

This high trading volume allows investors flexibility to buy and sell easily but also introduces greater price swings, making them ideal for those pursuing capital gains. Examples include:

• High Liquidity and Volatility: Common stocks are actively traded, resulting in narrow bid-ask spreads but also increased sensitivity to market changes.
• Market Growth Potential: During periods of high growth or favorable company performance, common stock prices may rise substantially, offering significant returns to investors. However, downturns can lead to notable price declines.

Preferred Stock, in contrast, appeals to income-focused investors who prioritize stability. With fixed dividends, preferred stocks offer consistent returns, providing a steady income stream and attracting conservative investors who prefer to hold long-term. Preferred stocks are generally less liquid than common stocks, meaning they trade less frequently and may have wider bid-ask spreads.

This lower trading frequency contributes to more stable pricing, with less susceptibility to short-term market sentiment, making them less volatile and better suited for investors focused on stable income.

• Fixed Income Stability: Preferred stock’s fixed dividends appeal to those seeking predictable returns and lower volatility.
• Reduced Liquidity: With a lower trading volume, preferred stock may come with wider bid-ask spreads and less flexibility for frequent trades, aligning with buy-and-hold strategies.

As Saxo Group puts it, “Preferred stocks tend to be less volatile than common stocks due to their fixed-income nature and priority in dividend payments. This stability can be reassuring during periods of market volatility, providing investors with a more predictable income stream and preserving capital.”

In my 10+ years of experience in the investing industry, I noticed that common stock tends to appeal to those comfortable with higher risk, while preferred stock resonates with income-focused, conservative investors.

Ownership Claims in Bankruptcy

When a company files for bankruptcy, understanding ownership claims becomes crucial.

In bankruptcy, preferred stockholders have a higher claim on assets than common stockholders, meaning they are more likely to recover part of their investment. Common stockholders are last in line after all creditors and preferred stockholders, which makes common stock a riskier choice in the event of a company’s financial distress.

These provisions ensure that the bankruptcy process can move forward without getting bogged down in lengthy ownership disputes, which is crucial for the efficient resolution of bankruptcy cases.

Conversion Rights Overview

Conversion rights offer unique flexibility for investors in certain types of preferred stock, allowing them to convert their preferred shares into common shares under specific conditions.

This feature can be advantageous, as it enables investors to participate in potential price appreciation of common stock if the company performs well.

Convertible Preferred Stock provides this option, often with predefined terms and conversion ratios. For example, one preferred share might convert to a set number of common shares if certain triggers such as a specific stock price or corporate event are met.

This setup offers preferred shareholders both the stability of fixed dividends and the possibility of capital gains through conversion.

Key benefits of conversion rights include:

• Upside Potential: Allows preferred shareholders to benefit from the growth potential of common stock.
• Flexibility: Shareholders can retain the option to convert, depending on market conditions.
• Strategic Advantage: For companies, offering convertible preferred stock can attract a broader range of investors, combining the appeal of fixed income with growth opportunities.

Conversion rights add a layer of strategic choice for both investors and companies, making convertible preferred stock an attractive option for those who want income stability with the potential to switch to growth-oriented common stock when favorable.

For more on growth-focused investment strategies, check out our guide on what is growth equity.

Secondary Market Liquidity

The secondary market plays a crucial role in the trading of both preferred and common stocks, providing a platform where these securities can be bought and sold after their initial issuance. This liquidity allows investors to adjust their portfolios, manage risk, and meet changing investment goals.

Common Stock typically has high liquidity in the secondary market due to frequent trading activity, allowing investors to easily enter and exit positions. This high liquidity is beneficial for short-term and active investors, as they can quickly react to market conditions and company performance.

• High Trading Volume: Common stocks often experience daily trading, leading to narrow bid-ask spreads.
• Flexible Trading: Investors can move in and out of positions quickly, aligning with short-term strategies.

Preferred Stock, on the other hand, generally has lower liquidity in the secondary market. It is usually issued in smaller quantities and tends to attract long-term investors focused on income. This can make preferred stock more challenging to trade swiftly, and transactions may come with wider bid-ask spreads due to lower demand and trading frequency.

• Lower Trading Volume: Preferred stocks are traded less frequently, impacting immediate buying or selling options.
• Wider Bid-Ask Spreads: Reduced trading can result in higher transaction costs for investors looking to buy or sell preferred shares.

The liquidity differences between common and preferred stocks in the secondary market make each suitable for distinct investor needs. Having worked extensively with investors, I can say that common stocks are ideal for those seeking flexibility and easy trading access, while preferred stocks align well with investors prioritizing income and are willing to hold their positions longer.

Investor Strategy and Preferences

Preferred and common stocks each align with specific investor strategies and preferences, reflecting differences in income needs and risk tolerance.

Institutional Investors often favor preferred stock for its stable dividends, which align well with income-focused portfolios. Institutions such as pension funds, insurance companies, and mutual funds rely on predictable returns to balance the overall portfolio against the volatility of other assets. Institutions are also better equipped to manage liquidity constraints, making them well-suited for preferred stocks with lower trading volume.

• Income Stability: Fixed dividends make preferred stock attractive for institutional portfolios focused on steady returns.
• Long-Term Holding: Institutions manage liquidity constraints well and often hold preferred stocks for reliable income over time.

Retail Investors are generally more drawn to common stocks, which are more accessible and offer greater growth potential. Common stock allows retail investors to benefit from capital gains and provides the flexibility of easy trading, which suits shorter-term strategies typical of retail investors.

• Growth Potential: Common stock appeals to retail investors seeking capital gains.
• Liquidity and Accessibility: The high trading volume of common stock offers flexibility for smaller investors.

These preferences highlight how institutional investors gravitate toward preferred stock’s income stability, while retail investors are likely to prioritize common stock’s growth and liquidity.

Impact on Corporate Control

Preferred and common stocks influence corporate control differently, particularly in terms of voting power, investor influence, and management priorities.

Common Stock typically grants voting rights, giving shareholders a voice in corporate matters like electing the board of directors and approving major business decisions. With more voting shares, common stockholders can exert a level of control that may impact a company’s strategic direction.

For companies with dispersed common stock ownership, shareholder activism can play a role in influencing policies, which may lead to more responsive corporate governance.

Key ways common stock impacts corporate control include:

• Voting Power: Common stockholders can vote on important company matters.
• Shareholder Activism: Larger or organized common shareholders may push for changes aligned with shareholder interests.
• Influence on Management: Frequent feedback and pressure from shareholders can shape management’s strategic decisions.

Preferred Stock generally does not come with voting rights, resulting in limited direct influence over corporate decisions. However, from what I’ve seen in the investing field, preferred stockholders’ priority in asset claims and dividends can indirectly affect corporate control by influencing company cash flows and financial decisions.

Companies often issue preferred stock to attract capital without diluting control among existing voting shareholders, making it a strategic choice for balancing financing needs with ownership retention.

Preferred stock influences corporate control in the following ways:

• Priority Claims: Preferred shareholders have first claim on dividends and assets, which can impact a company’s cash management.
• Capital Structure Flexibility: Issuing preferred stock enables firms to raise funds without altering voting control.
• Appeal to Passive Investors: Attracts investors interested in stable income rather than active control, allowing management to retain focus on long-term goals.

Tax Treatment Differences

Understanding the tax treatment of preferred and common stocks is essential, as it directly impacts investors’ after-tax returns. Tax treatment can vary significantly based on the nature of the income received and the holding period of each stock type, affecting both individual and institutional investors.

There are two primary types of tax differences that may affect stock investments:

Permanent Differences occur when tax treatment for certain income or expenses differs fundamentally from how it appears on financial statements. These differences don’t reverse over time. Examples include:

• Non-deductible expenses (e.g., fines or penalties) that are permanently excluded from tax deductions.
• Tax incentives for income earned in lower-tax regions, which can create beneficial permanent differences.

Temporary Differences represent timing mismatches between book and taxable income. These differences are expected to reverse in the future, ultimately aligning taxable income with book income. Examples include deferred rent income or stock options that cause temporary variances but eventually align once the timing issues resolve.

For investors, these tax treatments impact the overall effective tax rate (ETR), which is calculated by dividing total tax expense by earnings before tax.

Knowing how and when tax liabilities apply to each type of income helps investors better estimate after-tax returns, aligning their stock investments with their tax strategy and financial goals.

International Tax Considerations

Investing in preferred and common stocks across different countries introduces unique tax considerations due to varying tax rates, structures, and capital gains policies. These differences can influence investment decisions and after-tax returns, especially for investors with international portfolios.

Tax Rates vary widely between countries, impacting the effective tax rate (ETR) on dividends and capital gains. In the United States, for instance, individual income tax rates range from 10% to 37%, with additional considerations for dividend income and capital gains. Internationally, tax rates can differ substantially, affecting both domestic and cross-border investments.

Tax Structures also influence how investment income is taxed. In some countries, dividend income from preferred stock may qualify for lower tax rates, while in others, all dividends are taxed at the same rate as ordinary income. Corporate structures further affect tax implications:

• Pass-Through Entities: Entities like partnerships and S corporations in the U.S. avoid double taxation by passing profits directly to individual tax returns.
• Double Taxation: Traditional corporations (C corporations) face double taxation on earnings and dividends, impacting the net returns from common stock dividends.

Capital Gains Taxes apply to the profits made from selling common stock and can vary significantly across countries. These taxes may impact the appeal of common stock for growth-focused investors, as gains are taxed differently based on holding periods and income levels.

Historical Performance Comparison

When evaluating the historical performance of preferred and common stocks, it’s essential to consider differences in returns, risk, and stability over time. Analyzing these aspects helps investors understand which type of stock might better suit their long-term goals.

Historically, common stock has delivered higher long-term returns, largely due to capital appreciation. Business Insider reports that the S&P 500, which includes common stocks of major U.S. companies, has achieved average annual returns exceeding 10%, outperforming many other investments. However, this potential for higher returns also brings greater volatility, which might not be suitable for every investor.

Preferred stock, in contrast, offers more stable performance due to its fixed dividends. This stability is particularly attractive to conservative investors during periods of market uncertainty, as preferred stockholders continue to receive dividends even when stock prices fluctuate.

Real-World Examples of Preferred and Common Stock

To illustrate how preferred and common stocks function in real-world scenarios, let’s look at Bank of America’s approach to preferred stock dividends and Apple’s commitment to common stockholder value.

Preferred Stock Example: Bank of America (BAC)

Bank of America, as of late 2024, has announced multiple preferred stock dividends, ranging from 4.250% to 6.000% for various series. This diversity in preferred stock options reflects Bank of America’s strategy to provide steady returns to income-focused investors, demonstrating financial stability and the bank’s commitment to fulfilling its dividend obligations to preferred shareholders.

Common Stock Example: Apple Inc. (AAPL)

Apple Inc., listed under AAPL on the NASDAQ, is widely known for rewarding its shareholders through a combination of dividends and share buybacks. As of November 2024, Apple provides a dividend yield of 0.44% and an active buyback program, resulting in a total shareholder yield of 3.00%. This approach highlights Apple’s commitment to shareholder value, balancing dividend payments with share repurchases for flexible growth.

Frequently Asked Questions

Why would an investor choose preferred stock over common stock?

Preferred stock is appealing to investors who prioritize steady income over voting rights and potential capital gains. Its fixed dividends and priority in payouts provide income stability, especially in uncertain markets.

Can preferred stock be converted into common stock?

Some preferred stocks come with conversion rights, allowing them to be converted into common stock under specified conditions. This feature provides flexibility and potential for capital appreciation if common stock value increases.

Do preferred stockholders receive dividends before common stockholders?

Yes, preferred stockholders receive dividends before any are distributed to common stockholders. This priority is a core advantage, offering preferred stockholders a predictable income stream.

What happens to preferred and common stock in bankruptcy?

In bankruptcy, preferred stockholders have a higher claim on assets than common stockholders, meaning they are more likely to recover part of their investment. Common stockholders are last in line after all creditors and preferred stockholders.

Conclusion

Deciding between preferred and common stock depends on your investment goals and risk tolerance. Preferred stock offers stability and fixed dividends, which appeal to income-focused investors. In contrast, common stock provides voting rights and higher potential for long-term gains, attracting those willing to accept more risk for growth potential.

Understanding these differences helps you align your investment choices with your financial strategy and comfort level with risk. If you’re looking to grow your investment knowledge and learn more about finance career paths, take a look at our guide on how to get into venture capital for tips on breaking into this rewarding field.