How to Choose Between Common Stocks and Preferred Stocks: A Guide for Investors

Not all shareholders have the same rights within a company. When public companies issue shares, they offer different types, each with unique features regarding voting power, access to benefits, and priority over assets. The right choice depends on your financial goals and risk tolerance. Understanding the characteristics of common and preferred shares is essential for building a solid investment strategy.

Two main ownership pathways: fundamental characteristics

Companies mainly rely on two types of shares: common and preferred. Although both represent ownership in the company, their rights and benefits differ significantly.

Common Shares – The growth option:

• Grant voting rights at shareholder meetings
• Allow participation in profits (dividends), though these fluctuate based on performance
• Offer greater potential for capital appreciation
• In case of bankruptcy, are last in line to receive compensation
• Ideal for investors seeking corporate influence and long-term growth

Preferred Shares – The stability option:

• Usually do not confer voting rights
• Guarantee more predictable and priority dividends
• In liquidation, recover investment before common shares
• Limited growth potential compared to common shares
• Attractive to conservative investors prioritizing regular income

What distinguishes preferred shares?

Preferred shares occupy a hybrid space in the corporate financial structure, combining features of debt and equity. Although they are classified as equity on the books, they function more predictably than ordinary shares.

Their most relevant trait is dividend distribution. Unlike traditional debt instruments, these dividends do not create a legal obligation to repay capital, but they are often set at fixed or pre-established rates. This predictability makes them tools for generating consistent income.

Main variants of preferred shares

There are multiple categories tailored to specific strategies:

• Cumulative: Unpaid dividends accumulate for future periods
• Non-cumulative: Do not accrue rights to unpaid dividends
• Convertible: Can be transformed into common shares under certain conditions
• Redeemable: The company can buy them back at its discretion
• Participating: Dividends are directly linked to financial results
• With special protection: Include defensive clauses against specific corporate events

Rights and limitations in the corporate hierarchy

In a capital structure, preferred shares are positioned between pure equity and debt. Their holders gain priority over common shareholders during liquidations but are behind creditors and bondholders.

A critical aspect: these shares typically do not grant voting rights, limiting owners’ participation in strategic decisions. Additionally, their sensitivity to interest rate changes makes them resemble bonds, especially if they have features like mandatory redemption or fixed dividends.

Advantages and limitations for your investment

Benefits:

• Predictable income, generally higher than common shares
• Greater security in case of corporate insolvency
• Preference in dividend distribution
• Diversification of fixed/variable income in a portfolio

Disadvantages:

• Very limited capital appreciation potential
• Dividends may be suspended during financial crises
• No influence over corporate decisions
• Lower liquidity and sales restrictions
• Redemption clauses that limit potential returns

The nature of common shares

Common shares represent the most widespread form of equity participation. Unlike preferred shares, they offer direct exposure to business growth, albeit with inherent volatility.

Models of common shares

Though less common, variants exist:

• No voting rights: Participation in profits without decision-making influence
• Multiple classes: Each class confers different voting and dividend rights, allowing certain groups to maintain disproportionate control

Rights conferred by common shares

Voting power is their defining feature. Investors can influence key decisions: electing directors, approving mergers, distributing profits. In liquidation, common shareholders have priority only after creditors, bondholders, and preferred shareholders.

Dividends vary according to financial performance: during successful periods, they can be substantial; during economic uncertainty, minimal or none.

Advantages and risks of investing in common shares

Strengths:

• High liquidity for quick transactions
• Significant potential for capital appreciation
• Influence over company management through voting
• Direct exposure to economic growth

Weaknesses:

• Considerable price volatility
• Inconsistent dividends dependent on profitability
• Total loss risk in bankruptcy
• Exposure to economic cycles and market fluctuations

Comparative table: common vs. preferred shares

Choosing your path: strategies based on investor profile

For growth investors:

Common shares appeal to individuals with high risk tolerance, willing to endure volatility for significant gains. This profile, typical of early or mid stages of financial life, aims to expand wealth through capital appreciation. A long-term horizon allows overcoming market fluctuations and benefiting from prolonged bull cycles.

For income-focused investors:

Preferred shares are ideal for those prioritizing stability over expansion. Often in wealth preservation or retirement phases, these investors value predictable income streams. They seek to reduce risk exposure, leverage dividend preference, and liquidation priority. Many use them as diversification tools, balancing returns and volatility.

Recommended mixed strategy:

Combining both types allows optimizing the risk-return ratio. A balanced portfolio reduces vulnerability to specific cycles: if common shares decline, preferred shares maintain income generation; during economic expansions, common shares drive growth while preferred shares stabilize returns.

Market data: relative behavior of both types

To gauge actual behavior differences, analyzing the S&P U.S. Preferred Stock Index versus the S&P 500 is revealing. Representing about 71% of the preferred stock market in the U.S., this specialized index reflects the segment’s magnitude.

Over a five-year period amid changing monetary policy:

• S&P U.S. Preferred Stock Index: Down 18.05%
• S&P 500: Up 57.60%

This divergence underscores different behaviors. Preferred stocks, sensitive to interest rate hikes, declined; while common stocks, driven by corporate growth, advanced significantly. Data confirms the thesis: truly different risk-return profiles.

How to start your investment: practical steps

1. Choose your platform: Look for a regulated, reliable broker with competitive fees and a variety of available assets.

2. Open and fund your account: Complete identification and financial info; make an initial deposit according to your budget.

3. Analyze target companies: Review financial statements, sector, trends, competition, and growth or profitability prospects based on whether you choose common or preferred shares.

4. Execute strategic orders:

• Market order: immediate current price
• Limit order: set maximum/minimum price
• CFDs: alternative trading without ownership, if your broker offers and liquidity allows

Key management principles:

• Diversify: mix common shares, preferred shares, and other assets to reduce concentration risk
• Monitor: review your portfolio regularly, adjust based on market changes and evolving goals
• Rebalance: maintain your risk-return target ratio as positions change in value

Conclusion: the right choice based on your situation

Deciding between common and preferred shares is not universal; it depends on your age, time horizon, financial goals, and risk aversion. Young investors, with decades of accumulation ahead, typically prioritize common shares for growth. Those nearing retirement seek stability and predictable cash flows in preferred shares.

The market offers both types because diverse investors have different needs. Understanding their features, rights, risks, and return potential enables you to craft strategies aligned with your financial reality. A well-structured portfolio combines both, optimizing the balance between preservation and growth.