What Is the Difference Between Common and Preferred Stock?

What Is the Difference Between Common and Preferred Stock: Let’s Find out

Understanding the Two Main Types of Stock

When investing in the stock market, companies issue two primary types of stock: common and preferred. While both represent ownership in a company, they have some critical differences regarding rights, benefits, and risks. As the ancient Greek philosopher Plato once said, “The beginning is the most important part of the work.” Understanding these differences is crucial for investors to decide which type of stock to invest in based on their financial goals and risk tolerance.

Common stock is the most widely held type and typically provides voting rights, potential capital appreciation, and possible dividend payments. However, common stockholders are last in line for claims on assets and earnings in the event of bankruptcy or liquidation. In 2021, common stock accounted for approximately 80% of the total market capitalization of U.S. publicly traded companies.

On the other hand, preferred stock is a hybrid between common stock and bonds, offering higher priority on assets and earnings, fixed dividend payments, and potential preferential tax treatment. However, preferred stockholders usually do not have voting rights and limited capital appreciation potential. As of 2021, preferred stock comprised about 5% of U.S. stock market capitalization.

Legendary investor Charlie Munger, Warren Buffett’s long-time business partner, emphasized the importance of understanding the businesses behind the stocks. He once said, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you won’t make much difference than a 6% return—even if you originally buy it at a huge discount.”

Munger’s investment philosophy focused on identifying high-quality companies with substantial competitive advantages and holding them long-term. He believed that investors should “forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”

Common Stock: The Most Widely Held Type of Stock

Common stock is the most widely held type of stock and is what most people think of when discussing investing in the stock market. When you buy common stock, you become a part-owner of the company and have the right to vote on certain corporate matters, such as electing the board of directors and approving mergers or acquisitions.

One of the main benefits of common stock is the potential for capital appreciation. If the company performs well and its stock price increases, the value of your shares will also go up. Additionally, some companies pay dividends to their common stockholders, providing a regular income stream.

However, common stockholders are last in line regarding claims on the company’s assets and earnings. In bankruptcy or liquidation, common stockholders only receive what’s left after all creditors, bondholders, and preferred stockholders have been paid. This makes common stock riskier than preferred stock or bonds.

Preferred Stock: A Hybrid Between Common Stock and Bonds

Preferred stock is a type of stock that has characteristics of both common stock and bonds. Like common stock, preferred stock represents ownership in a company. However, preferred stockholders have a higher claim on the company’s assets and earnings than common stockholders.

One of the main benefits of preferred stock is that it typically pays a fixed dividend higher than the dividends paid to common stockholders. This makes preferred stock attractive to investors who prioritize income over growth. Additionally, preferred stockholders have priority over common stockholders when receiving dividends in the event of bankruptcy or liquidation.

However, preferred stockholders usually do not have voting rights, and their potential for capital appreciation is limited compared to common stock. Preferred stock prices are also more sensitive to changes in interest rates than typical stock prices.

Which Type of Stock is Right for You?

The choice between common and preferred stock depends on financial goals, risk tolerance, and investment strategy. If you’re looking for long-term growth and are willing to take on more risk, common stock may be the better choice. On the other hand, if you prioritize income and stability, preferred stock may be more suitable.

It’s important to note that investing in individual stocks, whether ordinary or preferred, carries more risk than investing in diversified mutual funds or exchange-traded funds (ETFs). Before making any investment decisions, it’s crucial to research, assess your financial situation, and consider seeking advice from a financial professional.

Focus on Strong Companies, Not Stock Classes

While understanding the differences between standard and preferred stock is essential, it shouldn’t be the primary focus when making investment decisions. Instead, investors should identify strong, well-managed companies with solid financial fundamentals and growth prospects.

One way to assess a company’s strength is to look at its financial statements, such as its balance sheet, income statement, and cash flow statement. These documents provide insight into a company’s assets, liabilities, revenue, expenses, and cash flow. Investors should also consider factors such as the company’s competitive advantage, market share, and management team.

Timing Your Entry: Buy When There’s Blood in the Streets

Once you’ve identified strong companies to invest in, the next step is to determine when to buy. One strategy is to wait for market pullbacks or crashes when stock prices are temporarily depressed due to widespread fear and panic selling.

The idea behind this strategy is to take advantage of market inefficiencies and buy stocks at a discount. When there’s “blood in the streets” and everyone is selling, it may be an opportunity to pick up shares of solid companies at bargain prices.

However, timing the market is notoriously tricky, even for professional investors. It’s essential to have a long-term perspective and not get caught up in short-term market fluctuations. Dollar-cost averaging, or investing a fixed amount of money at regular intervals regardless of market conditions, can effectively manage risk and take emotion out of the investing process.

Using Mass Psychology to Your Advantage

Another way to improve investment returns is understanding and taking advantage of mass psychology. As legendary investor Jesse Livermore once said, “The market is never wrong. Opinions often are.” Markets are driven by investors’ collective emotions and behaviours, which can lead to irrational decision-making and mispricing of assets.

For example, during the dot-com bubble of the late 1990s, investors became overly optimistic about the potential of internet companies. This led to a massive bull market where tech companies’ stock prices soared to unsustainable levels, even though many of these companies had little or no profits. Investors who recognized this irrational exuberance and sold their positions before the bubble burst could avoid significant losses.

Conversely, investors may become overly pessimistic when stock prices fall during bear markets and sell stocks at depressed prices, creating a market bottom. This happened during the global financial crisis of 2008-2009 when the S&P 500 index fell by more than 50% from its peak. Investors who could keep their emotions in check and buy stocks at these discounted prices were rewarded with significant returns in the following years as the market recovered.

By understanding these psychological dynamics, investors can identify opportunities to buy low and sell high. However, it’s important to note that trying to time the market based on psychology is a high-risk strategy unsuitable for all investors. As Livermore famously said, “There is only one side to the stock market, and it is not the bull or bear sides, but the right side.” Successful investing requires a disciplined approach, emotional control, and a focus on fundamental analysis rather than short-term market fluctuations.

Conclusion: A Balanced Approach to Stock Investing

In summary, while understanding the differences between common and preferred stock is essential, it shouldn’t be the sole focus of your investment strategy. Instead, investors should identify strong companies with solid fundamentals and growth prospects.

When timing your entry, buying during market pullbacks or crashes can be an effective strategy, but it’s essential to have a long-term perspective and not get caught up in short-term fluctuations. Additionally, understanding and taking advantage of mass psychology can improve investment returns, but it’s a high-risk strategy unsuitable for all investors.

Ultimately, a balanced approach that combines fundamental analysis, disciplined investing, and emotional control is likely the most effective way to achieve long-term success in the stock market. By researching, staying patient, and maintaining a diversified portfolio, you can maximize your returns while managing your risk.

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