There are several types of stocks. Two of which are categorized based on the rights and privileges attached to them by their using companies. These are common stocks and preferred stocks. Both represent fractional ownership. However, when compared to common stocks, preferred stocks have their notable advantages and disadvantages.
Pros: The Advantages of Preferred Stocks
Similar to common stocks, preferred stocks are ideal for aggressive investors. Note that investing in stocks has risks that are higher than other investment options such as bonds and the money market. However, compared to common stocks, choosing to invest in preferred stocks have several notable benefits or advantages. Take note of the following:
• Preference in Profits: Common stocks represent residual claims. Preferred stocks represent preferential treatment over the distribution of profits. This means that preferred stockholders are entitled to dividends, unlike common stockholders. Note that the dividends of common stocks are not guaranteed.
• Characteristics of Bonds: What makes preferred stocks appealing to certain investors is that they have characteristics of both common stocks and bonds. These stocks can provide a regular passive stream of income while also providing their holders with an opportunity to grow their wealth through capital appreciation.
• Priority During Liquidation: Another advantage of preferred stocks is that their holders are paid first before common stockholders in the event that a company liquidates. Note that common stockholders will only receive whatever was left after a company paid its creditors, bondholders, and preferred stockholders.
•Less Risky that Common Stocks: Remember that investing in stocks or the stock market is inherently riskier than investing in bonds and the money market. However, when comparing preferred stocks and common stocks, the latter are riskier because their prices are more volatile.
• Availability of Different Types: There are different types of preferred stocks that can meet the varying goals and objectives of investors. Convertible preferred stocks can be converted to common stocks. Participating preferred stocks pay extra dividends if the issuing company achieves its predetermined financial targets.
• Higher Yield Than Bonds: Note that the risk-return tradeoff tells that higher returns come with higher risks. Stocks might be riskier but they often outperform bonds. Preferred stocks have higher dividend yields than the yields of bonds, thereby making them ideal for aggressive investors looking to receive higher passive income.
From the perspective of companies, issuing preferred stocks allows them to raise capital while warding off potential hostile takeovers. Preferred stockholders have no voting rights, unlike common stockholders. Issuing companies can raise capital to fund their expansion and other facets of their operations without dilution of control.
Cons: The Disadvantages of Preferred Stocks
The advantages of preferred stocks make them appealing to certain investors. However, when compared to common stocks, as well as other investment options, it is not ideal to have an investment portfolio composed of these securities alone. The following are the drawbacks and disadvantages of preferred stocks:
• No Voting Rights: Investors seeking to be more involved in the direction of companies they want to invest in should choose common stocks instead. Common stockholders have the right to elect the board members of using companies and vote for corporate policies such as strategies, resolutions, and other companywide initiatives.
• Limited Capital Gains: Another disadvantage of preferred stocks compared to common stocks is that they have limited potential for capital appreciation. Common stocks have historically performed better than preferred stocks in terms of long-term gains, thus making them ideal for passive investing and buy-and-hold investment strategies.
• Dividends Are Not Absolute: It is true that preferred stockholders often receive dividends because they have preferential treatment over the distribution of profits. However, in some cases, issuing companies are not bound to pay dividends if their profits for a particular year are insufficient.
• Risks in the Stock Market: Preferred stockholders are also exposed to all of the risks of stock market investing. These include market risks due to the inherent volatility of the market and its sensitivity to macroeconomic factors, as well as management risks that arise from problems due to poor management and leadership.
• Interest Rate and Inflation: Stocks tend to outpace inflation. However, prolonged periods of high inflation rates or instances of hyperinflation can reduce the purchasing power of fixed dividends. Furthermore, when combined with high interest rates, thus resulting in stagflation, the profitability of companies is affected.
• Principal Risk: The value of stocks can depreciate. Furthermore, although preferred stockholders have priority over common stockholders when it comes to claims during liquidation, companies place their creditors and bondholders on top of their priority list. Preferred stockholders can suffer the same loss as common stockholders.
The long-term growth prospect of common stocks makes them appealing for passive investing and buy-and-hold investing. Furthermore, common stocks are traded in high volumes, thus creating a more active trading environment for companies and investors. Companies also incur higher costs with preferred stocks than they do when issuing bonds.