When you decide to invest, you’ll quickly realize that there are several different types of investment vehicles to choose from. Not only are there stocks, bonds, funds, and a wide range of other choices, there are different classes of assets.
Because beginner investors are often most comfortable purchasing stocks than other, less traditional investment vehicles, it’s important to understand the different classifications of stocks that exist and what they mean for people that invest in them.
What Is Stock?
A stock is an investment vehicle that represents a percentage equity ownership in a publicly traded company.
For example, if you own Apple stock, you actually own a piece of Apple, albeit a very small piece. There are around 17.1 billion outstanding shares of Apple. That means that if you own a share, you own 1/17,103,000,000 of the company. Apple is a massive company, valued at nearly $2 trillion, so even a small piece of this company is worth big bucks.
When you own a share or multiple shares of a company’s stock, you may assume that you’ll earn dividends, have first claim to the company’s assets should liquidation take place, or have an equal vote on important matters. But that isn’t always the case.
Your voting rights, dividend payments, and other benefits of ownership are largely determined not only by the public company represented by the stock you buy, but also by the type of stock you’ve decided to invest in.
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What Is Common Stock?
Common stock derives its name from the fact that it is the most commonly purchased type of stock. It goes by three different names. Other than common stock, you may hear this stock being referred to as ordinary shares or voting shares.
As with any other form of stock, common stock represents ownership in a public company. This type of stock also generally comes with voting rights, meaning that owners of common stock elect the board of directors, vote on corporate policies, and vote on many large financial transactions.
Common stock is also the type of stock that’s known for the most long-term gain potential, but that comes with risks of its own. Should a bankruptcy or liquidation take place, common stockholders are one of the last in line to have a claim to the assets. Bondholders, preferred stockholders, and debtholders will all be paid prior to common stockholders.
Understanding Common Stock Classes
Most publicly traded companies issue multiple classes of common stock. There is no rule determining the number of classes of stock a company is allowed to issue, or the enhancements or lack thereof that each class comes with. As a result, it’s important to do your research to understand the classes of stock available for the company you purchase prior to investing.
There are three common classes used by most publicly traded companies. These include:
Class A Common Stock
Class A common stock is generally the most valuable class. In many cases, Class A shares are reserved for management and other key parties within the company, as they generally come with enhanced voting power.
The benefits in owning this type of stock typically include:
- Enhanced Voting Power. In the vast majority of cases, Class A shares of common stock will have significantly more voting power than any other class of stock issued by a company. For example, at Warren Buffett’s firm Berkshire Hathaway, Class A shares hold 1,500 times more voting power than Class B shares.
- Dividend Priority. Class A common shareholders generally take priority when it comes to dividend payments. In the rare case that a company’s ability to pay its declared dividend entirely is compromised, the company will make an effort to pay its Class A shareholders prior to any other class. So, Class A common shareholders have greater claim to the company’s profits.
- Liquidation Priority. Should the issuer go out of business, file for bankruptcy, or otherwise liquidate its assets, all investors have a claim to a piece of the pie. However, there may not be enough to pay everyone. In these cases, Class A common shareholders are paid prior to other shareholders.
Class B Common Stock
Class B common stock is often the type of shares owned by the larger population of investors. While this stock does provide the shareholder with equity ownership, as all stock investments do, investors will not enjoy as much in the way of voting rights.
Although not all companies will have such a dramatic difference in voting rights between Class A and Class B common stock as Berkshire Hathaway, it’s important to get an understanding of just how much your vote counts if you’re interested in actively taking part in corporate decisions brought to the table by the company’s board.
In some cases, companies may designate more voting rights, priority in dividends, and liquidation priority to Class B common shares. While this is not the norm, it has led to the common misconception that Class B common stock is equal to preferred stock, but that couldn’t be farther from the truth — serving as yet another reason that taking the time to research your investment prior to making it is so important.
Finally, advisory shares of common stock are often provided to advisors of young start-up companies in lieu of cash payments for their advice. However, these are not generally shares of the company. Instead, they act as options, giving advisors the option to purchase a predetermined number of shares in the future at a heavily discounted rate.
Other Classes of Shares
Keep in mind that there is no limit to the number of classes of shares that a publicly traded company can issue, nor to the enhancements that can be designated to those classes. As a result, prior to making any investment, make sure that you know what class of shares you are getting and if there are any benefits or drawbacks specifically tied to that class of stock.
What Is Preferred Stock?
Preferred stock, like any other form of stock, provides the investor with an equity share of ownership in the public company represented by the stock. However, preferred stock describes a completely different asset type than common stock.
In fact, preferred stock is more like a hybrid of stocks and bonds than an investment in common stock. Common benefits associated with preferred shares include:
- Fixed Income. In most cases, preferred stockholders are offered a predetermined dividend in perpetuity, as is the case with loans that charge predetermined interest rates for the life of the loan. That means that, although common stock dividends may be adjusted, preferred stock dividends cannot. This offers preferred shareholders more stable income from their investments.
- Dividend Priority. When dividends are paid, preferred shareholders are paid first, even before Class A common shareholders. This adds yet another layer of stability to the income offered by these investments.
- Liquidation Priority. If a public company enters into a bankruptcy or liquidation, preferred shareholders will receive their payout before all classes of common shareholders, providing more protection for the investor’s value.
However, there is a trade-off here. While preferred stock tends to provide more stable income and priority, which reduces risk, the price growth in preferred stock tends to be far slower than growth in higher-volatility common stock.
Cumulative Preferred Stock
Cumulative preferred stock gives public companies a remedy in case dividend payments are not possible. In any event that causes the company to be unable to pay cumulative stockholders their dividend payments, the owed dividends will continue to accumulate until the point at which the company can pay these shareholders their cumulative dividend in full, which will take place before the payment of any noncumulative dividend payments.
Participating Preferred Stock
Participating preferred stock gives shareholders the right to be paid additional dividends. Not only will these shareholders be paid the predetermined dividend amount that preferred shareholders are generally paid, but an added dividend will also be paid based on a specific condition.
In most cases, this condition is based on dividends paid to common shareholders. Once dividends paid to common shareholders exceeds a predetermined amount, the additional dividend is paid to participating preferred stockholders.
Participating preferred stock also generally comes with increased liquidation benefits. Shareholders in this type of stock are paid prior to other preferred shareholders, as well as all common shareholders regardless of class.
Convertible Preferred Stock
Convertible preferred stock provides an added benefit to the shareholder. Not only does this type of preferred stock come with the predetermined dividend with dividend preference and liquidation priority, it also is convertible to a predetermined number of common shares after a predetermined date.
So, if common stock values rise at a rate that makes them more valuable than preferred stock, the holders of convertible preferred shares are able to convert their position to common shares in order to take advantage of the growth in market value. Once convertible preferred stock is converted into common stock, the move is irreversible.
Callable Preferred Stock
Callable preferred stock provides the issuer with an added benefit. Once a predetermined date has passed and a predetermined price has been met, the issuing company has the ability to “call” the preferred stock prior to maturity. This means that the company may buy back these shares at a premium in order to stop dividend payments.
In return for the benefit to the company, owners of callable preferred shares receive the dividends, dividend preference, and liquidation priority that all preferred shareholders do. They are also generally entitled to a call premium, helping the investor to lock in profits should the issuing company make the decision to call the shares.
Adjustable-Rate Preferred Stock
Adjustable-rate preferred stock comes with the same liquidation and dividend payment priority as other preferred stock. However, the amount of dividends paid to owners of these types of shares changes from time to time.
Generally, adjustments in the rate of dividend payments on adjustable-rate preferred stock take place on a quarterly basis, but they can happen more or less frequently. The rate of dividends is adjusted based on an underlying benchmark. While there are many benchmarks for publicly traded companies to choose from, the most common is the one-year Treasury bill rate.
When adjustments take place, the dividend payment on adjustable-rate preferred stock will be based on the benchmark plus a premium.
Key Differences Between Common Stock and Preferred Stock
When comparing the two main types of stock, common stock and preferred stock, some of the key differences that you should consider include:
One of the biggest differences between common stock and preferred stock is voting power. In most cases, holders of preferred stock have absolutely no voting rights. In contrast, the vast majority of common shareholders have a say in the direction of the company in which they’ve invested.
As a result, if you want to have a say — albeit a small one in most cases — in the operations of the companies you invest in, common stock is the way to go.
Access to and Amount of Dividends
Dividends are also a big difference. In most cases, income investors would rather invest in preferred shares than common shares for two key reasons:
- Amount of Dividends. Preferred shareholders are generally paid a higher dividend yield than common shareholders. Also, dividends with preferred stock are generally fixed, with adjustable-rate preferred stock being the exception. As a result, income investors are able to determine exactly how much income to expect when holding a preferred stock rather than being at the mercy of dividend adjustments associated with common stock.
- Dividend Priority. Preferred shareholders also receive priority when it comes to dividends. This means that they are more likely to be paid their dividends in full than common shareholders if money runs tight.
Access to Assets
Preferred shareholders also have a priority claim to assets in the event of liquidation. As a result, should the company’s fortunes go south, preferred shares are the better option because the investor is more likely to recoup their investment than common shareholders.
Common Stock Pros and Cons
Any investment vehicle you consider will come with its own list of pros and cons, and common stock is no different. Although there are plenty of reasons to consider common stock, there are also a few drawbacks that you should consider.
Pros of Common Stock
There are several perks involved in an investment in common stock. Some of the most important of these perks include:
1. Voting Power
Common stock tends to come with voting power. The idea that your vote counts is an ideal that the United States was built upon. Not only does it work well in politics, but voting also works well when it comes to investing.
With common stock, investors have a say in crucial decisions when it comes to policy and the running of the businesses they invest in. Although your personal share of the vote may be a very small one, your vote counts when you own common stock — along with all the other common shareholders out there — and that makes a difference.
Liquidity is a term used to describe how easy or difficult it is to sell a stock after you buy it. The easier it is to exit your investment, the more liquid the investment is. Conversely, investments that are difficult to resell lack liquidity.
Because common stock is the most common form of stock purchased, demand for common stock tends to be higher than demand for preferred shares. As a result, common stock tends to be the more liquid investment vehicle.
Finally, common stock comes with an increased level of risk over preferred stock, which generally means you can expect to see a stronger level of performance in your investment when things go right.
With preferred stock, investors tend to realize relatively slow growth, with the difference being made up in increased dividends and reduced risk. However, if you’re looking for momentous performance, common stock is the type of stock to buy.
Cons of Common Stock
Although there are plenty of reasons to consider an investment in common stock, there are also a few facts about this investment vehicle that may prove to be a turnoff. Some of the drawbacks to consider when investing in common stock include:
1. Last to Get Paid
In the event of liquidation or if the company lacks enough funds to pay dividends, owners of common stock are the last to get paid. Preferred shareholders receive dividends first. In the case of liquidation, bondholders, debtholders, and preferred shareholders will be paid first, often leaving little to nothing for common shareholders.
2. Variable Dividends
Not all common shares offer divident payments. If the company does decide to pay dividends, these payments will always be variable when paid to common stockholders.
This means that the underlying company can, at its discretion, reduce or completely eliminate dividend payments. As a result, investors who invested specifically for dividend income are left with returns that miss their expectations.
As a result, if you’re looking for strong income opportunities, you may want to consider investing in preferred stock over common stock.
3. Higher Risk
Finally, due to the fact that common shareholders are last to be paid, they inherit an increased level of risk when investing. After all, a company’s fortunes go wrong sometimes, and often warning signs of trouble ahead go unseen until it’s too late.
Unfortunately, common shareholders are the investors left holding the bag in these cases.
Preferred Stock Pros and Cons
With a name like “preferred” stock, you would think that this investment vehicle is perfect. However, there’s no such thing as a perfect investment vehicle that acts as a one-size-fits-all opportunity for the entire investing community. There’s always a downside to consider in any investment.
Pros of Preferred Stock
Preferred stock is an attractive investment vehicle that comes with plenty of benefits to consider. Some of the most important of these benefits include:
1. Access to Dividends and Assets Before Common Shareholders
Risk management is the single most important factor associated with preferred stock. These shareholders will receive payments prior to other shareholders in the event that dividend funds run low or the company goes belly up.
There’s always risk in any investment you make, but knowing that you’ll be paid prior to common shareholders makes it quite a bit easier to rest your head at night. That’s especially the case if you don’t have a large appetite for risk.
2. Added Enhancements
Like common stock, preferred stock isn’t all created equal. There are five different types of preferred stock, each coming with its own enhancements. As a result, when you invest in preferred stock, you get to pick through a list of perks that ultimately help to further reduce the risk in your investment.
3. Fixed Dividends
Fixed dividends is an important aspect for retirees and other investors who rely on the income generated through their investments. In most cases, with the exception of adjustable-rate preferred stock, dividend payments on preferred shares are fixed.
That means that the investor knows exactly how much money to expect and when for the life of the investment. There’s incredible value in that level of income stability for a large group of investors.
Cons of Preferred Stock
Although preferred stock comes with great benefits to consider, it’s not the perfect solution for all investors. As always, there are a few drawbacks that investors should think about before making an investment.
1. Underperformance When Compared to Common Stock
When investing in preferred stock, you can’t expect to see any monumental runs in value. This type of stock is known for relatively slow, steady growth.
If you’re an investor with a big appetite for risk and a desire to generate monumental growth, look to common stock.
2. Liquidity Concerns
Most investors buy common stock. In fact, if you ask the average beginner, most aren’t sure exactly what preferred stock is or even how to buy it. As a result, there is a much larger demand for common stock than there is for preferred stock.
This creates a new risk associated with preferred stock. Without as much demand, it may be difficult to sell your preferred shares in a timely manner. So, if you own preferred stock and need to quickly access your funds, you may find difficulty in doing so.
3. No Voting Power
By their nature, preferred stocks are passive investments. The idea is that the investor buys shares and holds them in hopes of generating stable income. However, as passive investments, preferred shares generally come with absolutely no voting power.
So, if you want to have a say in the moves the company you’re invested in is making, you’re better off buying common stock than preferred stock.
How to Buy Specific Types of Stock
When you log into your online broker and purchase shares, you’re going to be purchasing common shares by default. However, that doesn’t mean that access to preferred shares is limited to those with deeper pockets.
To gain access to preferred stock and different classes of common stock, all you need to do is call your traditional broker or log into your account with a discount online broker that offers access to preferred shares and place your order. Although you won’t find access to preferred shares on Robinhood, TD Ameritrade and many other discount brokerages do offer online access to preferred shares.
From there, your broker, whether traditional or discount, will guide you through the process of purchasing the types of shares you’re interested in.
Pro tip: If you’re going to add stocks to your portfolio, make sure you choose the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Determining whether you’re better off investing in common stock or preferred stock has to do with your investing goals. If you’re looking for momentous growth in your investment, and you’re not as concerned with generating income, common stock is the way to go. Moreover, you may be more interested in common stock if you’d like your vote to be heard when the company you’re invested in makes strategic changes.
On the other hand, if you’re looking for a more buy-and-hold investment that provides relatively stable growth and income, preferred stock may be the option for you. Although these shares won’t realize momentous growth and don’t offer voting rights, they do offer income that’s hard to compete with.