What is Common Stock vs Preferred Stock? No Need to Worry

What is Common Stock vs Preferred Stock? Understand the Difference

June 11, 2024

Introduction: Understanding the Difference between the two and Unveiling the True Value

When investing in the stock market, individuals often choose between purchasing common or preferred stock. While both represent ownership in a company, there are distinct differences in the rights and privileges afforded to each type of stockholder. In this essay, we will delve into the nuances of common and preferred stock, evaluate the hypothetical claim that there might not be a significant difference between the two, and explore the actual value that investors should focus on – timing their investments wisely by combining mass psychology and technical analysis.

Common Stock:

Common stock represents the most prevalent form of stock ownership. When individuals refer to owning company shares, they typically mean owning common stock. Holders of common stock have voting rights, which allow them to elect the company’s board of directors and vote on certain corporate matters. This level of influence is essential for active investors who wish to have a say in the company’s decision-making process.

One of the primary attractions of common stock is the potential for capital appreciation. Unlike preferred stock, common stock typically has no predetermined dividend amount. Instead, holders of common stock receive dividends that vary in amount and are declared at the discretion of the company’s board of directors. This variability means common stockholders can benefit from higher dividends when the company performs well and profits are substantial. Additionally, in the event of company liquidation, common stockholders have a claim on the company’s assets after the claims of creditors and preferred stockholders have been satisfied.

Preferred Stock:

As the name suggests, preferred stock offers specific preferences and privileges to its holders. One key advantage of preferred stock is its priority in terms of dividend payments. Preferred stockholders are typically guaranteed a fixed dividend amount, usually paid at regular intervals. This stability provides a predictable income stream that attracts income-oriented investors or those seeking a more conservative investment approach.

Another distinguishing feature of preferred stock is its preference in the event of liquidation. In the unfortunate scenario where a company needs to be liquidated, preferred stockholders have a higher priority claim on the company’s assets compared to common stockholders. This means they will be paid out before common stockholders, protecting their investment.

Furthermore, preferred stock often carries a feature known as “convertibility.” This means that preferred stockholders can convert their preferred shares into a predetermined number of common shares. This flexibility can be advantageous if the common stock performs well and the investor wishes to benefit from the potentially higher dividends and capital appreciation associated with common stock ownership.

Testing the Hypothesis: Is There Real Value in Chasing One Over the Other?

The hypothesis suggests that investors should focus more on timing the market and buying at the right moment rather than fixating on the type of stock. To assess this claim, let’s examine the evidence and explore the value investors should consider.

Evidence from Market Trends:

Historical data suggests that market trends and timing play a crucial role in investment success, regardless of the purchased stock type. For instance, let’s consider the performance of the S&P 500 index, which is often used as a benchmark for the overall stock market.

If an investor had purchased the S&P 500 index fund, representing a diverse basket of common stocks, at the market peak in October 2007, just before the global financial crisis, they would have endured a significant decline in their investment value. However, if the same investor had waited and bought at the market bottom in March 2009, they would have benefited from the subsequent market recovery, potentially doubling or tripling their investment within a few years.

Similarly, let’s examine the performance of preferred stocks during the same period. The iShares U.S. Preferred Stock ETF (PFF), which tracks an index of preferred stocks, exhibited similar trends. Buying at the peak in 2007 would have resulted in substantial losses while purchasing at the market bottom in 2009 would have yielded significant gains.

These examples illustrate that the timing of the investment, driven by mass psychology and technical analysis, plays a more crucial role in investment success than merely choosing between common and preferred stocks.

Mass Psychology and Market Timing:

Mass psychology tells investors a lot about the right time to invest. When the masses are overly excited, and the market is experiencing a frenzy, it is often a sign of overvaluation and an impending correction. On the other hand, when panic sets in, and investors start selling off their holdings indiscriminately, it presents a valuable opportunity to buy.

For instance, during the dot-com bubble in the late 1990s, mass excitement and speculation drove technology stock prices to unprecedented highs. However, this was followed by a sharp market correction as the bubble burst, causing many investors to lose significant wealth. In contrast, the 2008-2009 financial crisis saw panic selling across the board, driving stock prices to shallow levels. Investors who bought during this period of mass panic and held on to their investments were rewarded with substantial gains as the market recovered.

Combining Mass Psychology and Technical Analysis for Improved Timing

While it is impossible to time the exact bottom or top of the market, combining mass psychology with technical analysis can help improve investment timing. Technical analysis involves studying historical price patterns, trading volumes, and other statistical data to identify potential buy or sell signals.

Indicators for Improved Timing:

Relative Strength Index (RSI): The RSI is a momentum indicator that measures the speed and change of price movements. It helps identify overbought or oversold conditions in a stock or the broader market. When the RSI reaches extreme levels, it indicates that a reversal may be imminent.

Moving Averages: Moving averages, such as the 50-day and 200-day moving averages, help smooth out price data and identify the direction of the prevailing trend. When short-term moving averages cross above long-term moving averages (a golden cross), it indicates a potential buy signal, while a death cross (short-term moving average crossing below the long-term moving average) suggests a potential sell signal.

Bollinger Bands: Bollinger Bands consist of a moving average and two standard deviations, providing an envelope around price movements. When prices touch or exceed the upper band, it suggests a potential overbought condition, while prices reaching the lower band indicate an oversold condition.

Volume Indicators: Analyzing trading volume can provide insights into the strength of a price movement. Increasing volume during an upward price movement confirms the trend’s strength while decreasing volume during a price decline suggests a potential reversal.

By combining these technical indicators with an understanding of mass psychology, investors can improve their timing and make more informed investment decisions.

Conclusion

In conclusion, while common stock and preferred stock differ in rights, privileges, and dividend structures, the true value for investors lies in mastering market timing and understanding mass psychology. As Confucius wisely noted, “The cautious seldom err,” emphasizing the importance of strategic decision-making. Similarly, Aristotle’s insight that “knowing yourself is the beginning of all wisdom” underscores the necessity of self-discipline and awareness in investing. The hypothesis that there might not be a significant difference between chasing one type of stock over the other holds merit, as evidence suggests that buying at the right time, guided by mass psychology and technical analysis, is paramount to investment success. By combining these ancient insights with modern strategies, investors can refine their timing, make more profitable decisions, and ultimately, build enduring wealth.

Moreover, the market reflects human behaviour and emotions. Laozi once said, “A journey of a thousand miles begins with a single step,” reminding us that patience and persistence are crucial. Successful investors understand the cyclical nature of markets and use tools like the Relative Strength Index and moving averages to navigate these cycles. By doing so, they can better identify opportunities to buy when others panic and sell when euphoria reigns, thus achieving long-term financial prosperity.