Common vs. preferred stock

Businesses raise money from investors by selling stock in one of two flavors: common stock or preferred stock. Both common stock and preferred stock can be worthwhile investments, and you can find both types of stock on major exchanges.

There are many differences between common and preferred stock, though, and depending on your needs, one type of stock may be a more suitable choice for you than the other. Even though its name might suggest that preferred stock is a better investment, most investors should focus on common stock because of its potential for unlimited growth.

Common stock

Common stock gives investors partial ownership in a company. Many companies exclusively issue common stock to investors, and there's a lot more common stock available on stock exchanges than preferred stock.

Investors holding common stock typically have the legal right to vote to name representatives on the company's board of directors and to approve major corporate decisions, such as mergers. Common shareholders also have the right to receive any dividends that the company declares on their shares.

The most attractive feature of common stock for investors is that its value can rise dramatically over time. As a company becomes more successful, its common stock price typically goes up. The most lucrative common stocks have seen their prices multiply a hundredfold or more over the course of a company's history.

Bear and bull statuettes

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However, common shareholders have the lowest priority for getting any of their money back when a company fails. Creditors who lend money to the company typically must get paid in full before any shareholder -- common or preferred -- can receive anything from the liquidation of a company's assets. Even if there's something left over after creditors have gotten paid, preferred shareholders still stand ahead of common shareholders up to a certain maximum amount. Only if anything's left over will common shareholders get the rest.

Most of the time, companies have just one class of common stock. Sometimes, though, companies will issue two or more classes, especially if they want one class of shareholders to have different voting rights than another class.

Read More: Common Stock

Preferred stock

Some companies also issue preferred stock, and the features of preferred stock can differ greatly from common stock. In fact, preferred stock often looks a lot more like a bond, as it typically has a set dollar amount that the company can pay preferred shareholders to redeem the shares. Most preferred stock pays dividends, and the amount tends to be higher than what common shareholders receive. Preferred stock usually pays fixed dividends year in and year out, rather than seeing changes in payout amounts from quarter to quarter as common stock dividends are.

The label "preferred" comes from two advantages that preferred stock has over common stock.

  1. A company must pay out dividends to preferred shareholders before common shareholders receive any dividends.
  2. If a company fails and its assets get distributed to investors, preferred shareholders must receive a fixed amount of money before common shareholders can get any of their investment back.

Those attributes make preferred stock especially attractive for investors whose primary focus is on income. Most preferred stock won't see large price increases even if the company that issued it is successful. However, predictable dividends that have priority over common stock dividends give preferred shareholders more confidence that the company will pay out the income they need.

Keep in mind the one major disadvantage to preferred stock: preferred shareholders often don't get any vote on corporate matters.

There's no limit to the number of different preferred stock classes a company can issue. It's not unusual for a company to define multiple preferred share classes, featuring different dividend rates and dates at which the company can redeem the stock by paying investors their capital back.

Companies can also issue convertible preferred stock. In addition to having the normal attributes of preferred stock, convertible preferred gives the shareholder the right to take their preferred shares and convert them into regular common stock under certain circumstances. The conversion right gives convertible preferred stock more upside potential than regular preferred stock, making it an attractive option for some investors who like the combination of higher dividend income and possible share price increases over time.

Read More: Preferred Stock

The table below can help you see the key differences between common and preferred stock more clearly.

Factor

Common Stock

Preferred Stock

Upside potential

Almost unlimited

Limited to redemption value, except for convertible preferred

Downside risk

Can fall to $0

Can fall to $0 but is less likely to do so

Share price volatility

More dramatic movements

Less dramatic movements

More suitable for...

Long-term growth investors

High-yield dividend investors

Number of classes of stock

Usually 1; sometimes more if there's a need for special voting rights

Often multiple, with no limit on how many a company can issue

Chart by author.

Most investors want stocks as investments because they're interested in long-term growth for their portfolio. For them, common stock is usually the better choice, because the greater upside potential from common stock is of paramount importance. For growth-oriented investors who like the features of preferred stock, choosing a convertible preferred can also be a smart move.

If your primary focus as an investor is on current income, however, preferred stock can give you more of what you're looking for. With fixed dividend payouts that are more reliable than dividends on common stock, preferred stock can increase the amount of income you get from your investments while also reducing the overall risk level of your portfolio compared to owning common stock.