With a good investment strategy, it is possible to amass hundreds of thousands, if not, millions of dollars in wealth over the long term. As part of your financial plan, you may weigh the benefits of buying preferred shares against common shares. To do so, you must become familiar with the basics of corporate finance and asset claims. From there, you can better analyze the risks versus rewards of owning preferred and common shares.
Preferred Shares Versus Common Shares: Asset Claims
Preferred shares take their name from the fact that they feature senior asset claims above common shares. Preferred dividends are cumulative and any missed preferred dividend payments must be paid out before common shareholders receive any dividends. In the event of bankruptcy, preferred shareholders will also collect cash from the proceeds of any liquidated assets before common shareholders. Both preferred and common shares, however, are junior to bonds. The corporation is legally mandated to make interest payments, but pays out dividends at its discretion.
Preferred Shares Versus Common Shares: Risks Versus Rewards
Preferred and common shares owe their respective risk versus reward profiles to their asset claims. Because common shares are junior securities, their performance closely tracks corporate profits. As such, common share prices can swing wildly between infinity and zero during economic boom and bust.
Alternatively, preferred shares feature relatively stable share prices. Preferred shares typically pay out a fixed dividend in perpetuity, which makes for performance that closely resembles that of bonds. Preferred shares are therefore more so affected by inflation and interest rate risks. Inflation refers to a rising price level for goods and services, which erodes the purchasing power of future dividends. In terms of interest rate risks, your preferred shares are likely to lose value when interest rates rise. At that point, new bonds and fixed income assets will generate more investment income than old preferred shares.
Preferred Shares Versus Common Shares: Voting Rights
With common stock, one share equals one vote upon corporate matters. Acquirers target common stock, because one investor can effectively control a corporation if he owns more than 50 percent of its outstanding common stock. From there, the investor can make an offer for all of the corporation’s outstanding common stock and take the business back private.
Preferred shares, however, do not carry voting rights. As such, a corporation will often make convertible preferred shares a part of a poison pill to deter hostile takeovers. A poison pill works by allowing preferred shareholders to convert their positions into large amounts of common shares, if one investor acquires a set percentage of the company. A poison pill may therefore make for a takeover deal that is prohibitively expensive.
Preferred Shares Versus Common Shares: Warning
Preferred and common shares are both susceptible to systematic risk. Systematic risk relates to the collapse of the financial system – where all asset prices decline toward zero. To manage risks and invest for growth, you should combine bank deposits alongside preferred and common shares within your portfolio. As of 2011, the FDIC guarantees $250,000 worth of deposits per customer, per bank.
Preferred Shares Versus Common Shares, Sources:
Investopedia: A Primer on Preferred Stocks
Investopedia: Common Stock
SEC: Convertible Securities
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