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A preferred stock can provide regular fixed dividend payments while giving investors an ownership stake in the company. In this way, it functions like a combination of a stock and a bond. That can be attractive to investors, but there are potential downsides that could affect your financial goals. Understanding how preferred stock works can help you decide if it makes sense for your portfolio.
What Is Preferred Stock?
A primary way publicly traded companies raise capital is by selling shares of common stock. In exchange, investors receive a slice of equity (or ownership). Preferred stock is a type of specialty stock that provides the stability and income you'd expect from a bond, plus the equity you'd get from a common stock. Preferred stocks typically pay regular fixed dividends and are considered safer investments than common stock. However, growth potential may be limited.
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Preferred Stock vs. Common Stock
Both preferred stock and common stock give investors an equity position in publicly traded companies, but they serve different investing goals. Preferred stock prioritizes income and dividend payments, which some companies issue to shareholders as a way of distributing profits. Companies may offer both preferred stock dividends and common stock dividends, but preferred stock payments tend to be higher.
Common stock, on the other hand, prioritizes voting rights. By investing in common stock, you have the right to vote at shareholder meetings and participate in electing directors. In this way, you get to play a role in how the company is managed.
Common stock also tends to offer more growth potential. If a company is successful, its common stock price could increase substantially—allowing investors to realize significant capital gains if they sell their shares for more than they paid. However, preferred stock prices are tied more to interest rate fluctuations, similar to the way bonds are structured. To put it another way, preferred stocks offer steady income, while common stocks offer the potential for bigger gains.
| Preferred Stock | Common Stock | |
|---|---|---|
| Ownership | Yes (in the form of equity) | Yes (in the form of equity) |
| Voting rights | No | Yes |
| Dividends | Virtually all preferred stocks pay dividends | Common stocks may or may not pay dividends |
| Growth potential | Less growth potential | Greater potential for capital gains |
| Risk level | Lower risk, but total returns may lag behind common stock shares | More vulnerable to market volatility |
Pros and Cons of Preferred Stocks
Like common stocks and other investments, preferred stocks have benefits and drawbacks. Here are some important things to consider before deciding if they're right for you.
Pros
Steady dividend payments: Preferred stocks typically pay fixed, recurring dividends. That can unlock a reliable income stream for investors.
Less volatility: While common stock prices can fluctuate wildly based on market conditions, preferred stock prices tend to be more stable.
Priority in the event of bankruptcy: If the company experiences a liquidation event like bankruptcy, bondholders will be paid out first. Preferred stock shareholders are next in line, ahead of investors who own common stock.
Cons
Weaker growth potential: If the company performs well and common stock prices soar, investors with preferred stock won't be positioned strongly to capitalize on that growth.
Interest rate risk: Similar to bonds, preferred stock prices tend to fall as interest rates increase (and vice versa). That can make them less valuable when rates are trending upward.
Income isn't guaranteed: If a preferred stock is callable, the issuer could force you to cash out your outstanding shares—cutting you off from future returns. It's also possible for a company to skip dividend payments with no obligation to make them up to shareholders.
Should I Buy Preferred Stocks?
The answer depends largely on your investment goals. Below are some important things to think about when evaluating preferred stock.
When Preferred Stock Might Be a Good Investment
- You prefer regular income payments over potential gains
- You want to be better protected if the company declares bankruptcy
- You don't mind giving up voting rights in exchange for steady dividend payments
When Common Stock May Be a Better Option
- Your main investment goal is long-term growth
- Voting rights and corporate governance are important to you
- You want stocks that can stay competitive with current market prices
How to Buy Preferred Stocks
If you're interested in preferred stocks, you can purchase them through a:
- Regular brokerage account
- Individual retirement account (IRA)
- 401(k) if your plan offers a self-directed brokerage account
If researching individual stocks feels daunting, a preferred stock fund may be a better fit. That may be an exchange-traded fund (ETF) or mutual fund that focuses on preferred securities. These allow you to buy and hold groups of stocks, which can provide diversification and help minimize investment risk.
Frequently Asked Questions
Who Buys Preferred Stocks?
Anyone can buy preferred stocks, though they're most commonly held by institutional investors. These are professional investors who operate on behalf of larger institutions like banks, mutual funds or insurance companies.
Does Preferred Stock Have Voting Rights?
Unlike common stock, preferred stock generally does not give shareholders voting rights.
What Is a Convertible Preferred Stock?
This operates like a regular preferred stock, but shareholders have the option to trade it in for a certain amount of common shares. That can allow investors to take advantage of growth periods.
What's the Difference Between Preferred Stocks and Bonds?
Like preferred stocks, bonds can provide steady income with less risk than traditional stock investing. Bonds and preferred stocks are also affected by interest rates in similar ways. However, they do have some noteworthy differences:
- Bonds don't provide equity. Purchasing a bond is like extending a loan. The issuer is obligated to repay you, with interest. That makes you a debt holder and doesn't buy you an ownership position.
- Bonds are safer than preferred stocks. If a company faces bankruptcy, bondholder payments will take priority over preferred stock payments.
- Preferred stocks typically offer better returns. Dividend payments from preferred stock may be higher than corporate bond yields.
The Bottom Line
Preferred stock is a unique type of asset that sort of functions like a stock and a bond rolled into one. They can provide regular income, thanks to fixed dividend payments, but growth potential is often limited. Your investment goals will ultimately determine if preferred stock belongs in your portfolio.