COMMON VS PREFERRED SHARES EXPLAINED
Discover the pros and cons of investing in common vs preferred shares, including key differences in voting rights, income potential, and risk exposure.
What Are Common and Preferred Shares?
When investing in equities, shares represent ownership in a company and come primarily in two forms: common shares and preferred shares. Each type offers distinct benefits and limitations in terms of voting rights, income potential, rights to company assets, and risk levels. Understanding these differences is crucial for investors aiming to make informed portfolio decisions.
Common Shares
Common shares are the most frequently issued type of stock. When people discuss buying stock in a company, they are usually referring to common shares. Holders of common shares typically have:
- Voting rights: Shareholders can vote on critical corporate matters, like electing the board of directors or approving mergers and acquisitions.
- Payout potential: Shareholders may receive dividends, although these are not guaranteed and vary based on company performance.
- Residual claim on assets: In the event of bankruptcy, common shareholders are paid after debt holders and preferred shareholders.
Because of their exposure to both the upside and downside of a company’s performance, common shares can offer high returns along with high risk. They also typically have more price volatility than preferred shares.
Preferred Shares
Preferred shares generally offer a different risk-to-reward profile and tend to have features more associated with fixed-income securities than equities. Key characteristics include:
- No or limited voting rights: Most preferred shareholders do not have voting privileges.
- Fixed dividends: Preferred shares usually pay a fixed dividend, which is paid before any dividends on common shares.
- Priority claim on assets: In the event of liquidation, preferred shareholders are paid before common shareholders but after bondholders.
- Callable and convertible features: Many preferred shares are callable (can be repurchased by the company) or convertible (can be exchanged for a predetermined number of common shares).
Preferred shares are particularly attractive to income-focused investors due to their regular dividend payments. However, they generally offer less capital appreciation compared to common shares.
Key Differences at a Glance
| Feature | Common Shares | Preferred Shares |
|---|---|---|
| Voting Rights | Yes | Usually No |
| Dividend Priority | Lower | Higher |
| Price Volatility | Higher | Lower |
| Claim on Assets | Last | Before common shares |
| Conversion Features | Rare | Common |
In summary, investors need to align their choice between common or preferred shares based on their risk appetite, income needs, and desire for influence in company decisions.
Pros and Cons for Investors
Whether an investor opts for common shares or preferred shares depends on their financial goals, time horizon, and risk tolerance. Each type of share has distinct advantages and disadvantages that affect investor returns, influence, and protection.
Advantages of Common Shares
- Upside potential: Common shares have greater potential for capital appreciation over time, driven by the company’s performance.
- Voting rights: Investors can participate in governance decisions, such as electing board members or approving strategic initiatives.
- Liquidity: Common shares are widely traded on stock exchanges, making them more liquid compared to preferred shares.
Disadvantages of Common Shares
- Dividend uncertainty: Dividends are not guaranteed and may not be issued regularly.
- Last in line: In bankruptcy scenarios, common shareholders receive assets only after all other obligations are met.
- Higher volatility: Prices can fluctuate significantly, which may not suit risk-averse investors.
Advantages of Preferred Shares
- Stable income: Fixed dividend payments provide regular income, appealing to retirees and income-focused investors.
- Less volatile: Preferred shares generally exhibit price stability compared to common equity.
- Priority claims: In bankruptcy, preferred shareholders are paid before common shareholders.
Disadvantages of Preferred Shares
- Limited growth: Less opportunity for capital appreciation limits long-term wealth generation.
- Lack of control: Most preferred shares do not come with voting rights, reducing investor influence.
- Callable risk: Issuers often retain the right to repurchase shares, potentially limiting future gains.
Risk-Return Profile
From a risk-return perspective, common shares appeal to those seeking growth and are willing to bear higher price volatility. Preferred shares are attractive to conservative investors prioritising steady income over capital appreciation.
Tax Considerations
In many jurisdictions, dividends from both common and preferred shares may be taxed differently. Investors should evaluate the dividend classification (qualified vs. non-qualified in the U.S., or franked vs. unfranked in Australia, for example) and understand their specific tax implications.
Portfolio Positioning
An investor’s asset allocation strategy should influence their choice. For example:
- Growth portfolios: Better suited to common shares due to capital appreciation potential.
- Income portfolios: May favour preferred shares for their regular dividend yield.
- Diversified strategies: Using a blend of both can balance risk and income.
Ultimately, the choice between common and preferred shares is not mutually exclusive. Many investors use both to optimise portfolio performance across various market cycles.
Making the Right Investment Choice
Choosing between common and preferred shares involves aligning investment objectives with each security’s unique characteristics. What may work well for one investor may not suit another, making due diligence essential.
Key Factors to Consider
- Investment goals: Are you seeking income, growth, or a combination of both?
- Risk tolerance: Can you accept short-term volatility for higher long-term gains?
- Time horizon: Longer-term investors may tolerate risk, while short-term investors might prioritise income.
- Market outlook: In a rising interest rate environment, preferred shares may lose value as newer issues offer higher yields.
- Tax implications: Understand how each type of dividend is taxed in your jurisdiction.
Real-World Examples
Consider an investor nearing retirement seeking consistent income: preferred shares would likely align better with their objectives due to their fixed dividend returns and lower volatility.
In contrast, a young investor aiming to grow wealth might favour common shares for their upside potential, even if that means accepting higher levels of risk.
Hybrid Share Structures
Some companies offer hybrid securities that blend features of both common and preferred shares. These may include:
- Convertible preferred shares: Allow the holder to convert to common shares under specific conditions.
- Participating preferred shares: Offer fixed dividends and additional payouts if company profits exceed a threshold.
These alternatives give investors flexibility but also introduce complexity, requiring a deeper understanding of terms and conditions before investing.
Professional Guidance
Given the nuanced differences between common and preferred shares, many investors consult financial advisors or wealth managers to customise an equity strategy that reflects their goals, tax status, and risk appetite. Independent research using prospectuses, annual reports, and financial news also helps investors evaluate the long-term viability of both share classes.
Conclusion
Common and preferred shares serve different purposes within an investment portfolio. Common shares offer governance rights and capital growth, suited to those comfortable with market swings. Preferred shares deliver income and stability, preferable for conservative investors. Evaluating both in the context of your overall strategy can help create a resilient and diversified portfolio.
