The stock market is followed closely by many and casually by many more. When the market is particularly volatile even the usually casual observer begins to pay attention and wonder about market terminology. Two terms frequently heard: common stock and preferred stock.
Many people are surprised to discover that stocks come in two different forms and wonder which one they should buy. The difference between the two types of stock is mainly a matter of risk. Common stock is also referred to as ordinary stock and carries greater potential income as well as greater risk. The amount of income and degree of risk depends in part on the economy as a whole and on the type of stock for investment. Blue chip stocks carry the least risk while the more volatile stocks quickly produce financial gain or just as quickly lead to financial loss.
Preferred stock is different from common stock in that it is bought at a negotiated price with certain predetermined conditions not available to common stock holders. While common stock only comes as a one size fits all instrument, preferred stock is tailored to fit what the investor wants in the way of risk and is willing to pay for in a special agreement.
Some types of Preferred stocks:
Most stock is cumulative, which means that the agreed upon dividend is considered a debt when the company is unable to pay it on time. Common stockholders collect dividends when a company does well but cannot be paid until preferred stockholders have been paid the dividend they were promised in their preferred stock agreement. In the event that the company cannot pay even the preferred stockholders dividends then the owed dividends are considered to be in arrears or as a debt and must be paid up before any dividend can be paid to others.
One of the perceived advantages to common stock is that if a company does fantastically well the common stock holders can share in the success with larger dividends. However, although preferred stock normally has a fixed dividend rate, with participating preferred stock a preferred stockholder can partly share in any phenomenal success of the company. A formula, spelled out in the prospectus, allows for the possibility of earning more then the agreed upon dividend rate when common stock dividends are particularly high.
Callable preferred stock has a date and price spelled out in the prospectus when it can be redeemed. This is in contrast to common stock that can be sold at any time, but only at the current going rate.
Convertible: Convertible preferred stock can, like bonds, be converted to common stock. When and at what price the stock can be converted is laid out in the preferred stock’s prospectus.
Basically the investor has more options by investing in preferred stock but will have to pay more to reduce the risk that would accompany common stock. In the eventuality of a company going into bankruptcy, preferred stockholders are reimbursed after all creditors have been paid but before common stockholders can receive any money.
Perhaps the best way to describe the differences between common and preferred stock is this: Common stock and bonds are at opposite ends of the risk verses earning potential spectrum with the various types of preferred stock somewhere between them.