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What Is Common Stock and What Is Preferred Stock? Stock Types and Their Differences Explained

NEW YORK (TheStreet) -- When you step into the investing jungle, what will you find there? Lions (stocks) and tigers (bonds) and bears (cash), for sure. But they're not as scary as you think.

These three are the main investment classes, but the one we'll be tracking exclusively in this guide is the king of the jungle: stocks.

You may have heard stocks referred to as equities or securities. The reason they're called equities is that you purchase an equity, or ownership, share of a company. Stock is also called a security for the same reason, because you're securing a share of ownership in the company. That's right; you'll be a business owner just like you've always dreamed!

But, as you know from everyday life, there are terrifically run businesses and there are businesses that make you say, "I'll never go back there again!" How do you know the difference before you buy the stock? That's what this guided tour will be teaching you.

So when you buy stock, you become part owner of the company -- maybe only a very small part, but still an owner. The size of the part you own, by the way, is irrelevant to your personal objectives.

We won't cover bonds in this guide, but it's important for you to know that they're out there in the investing jungle. When you buy a bond, you don't become part owner of a company -- you're the bank! You lend the company, or others, money. When companies, counties, municipalities or the U.S. government need to raise money, but not raise taxes or prices, they have bond offerings.

Bonds are loans, with a maturity date, and a percentage rate, promised to you, the Bank of I.O.U.! The maturity date and set percentage rates can make bonds an attractive investment as part of a stabilizing influence in your investment portfolio. But you don't want just bonds in your portfolio -- over the long haul, stocks outperform bonds. If you want to purchase and own bonds, it's very important to have quality bonds in your portfolio. If you want to continue to learn about bonds, see "Why Buy Bonds?"

When financial advisers suggest you diversify, or vary your investments, they're advising you to spread out any potential risk, or decline, in your investment portfolio. Your investment portfolio is a collection of all of your investments, which could include assets from each of these three classes.

It's like a nutritionist telling you to eat a little bit of each type of food to maximize your health. A balance of green vegetables, lean meats, dairy products and whole grain breads keep you physically and mentally healthy. Likewise, you want to invest your money in a variety of assets in your portfolio: stocks, bonds and cash products. Cash investments include products such as certificates of deposit (CDs) and money market mutual funds that keep you financially healthy.

Ready then? Get out your compass.

Which Type of Stock Should You Pick?

Wow, our jeep just rounded a clearing, and there they are -- a pride of lions (stocks). It's interesting -- there seem to be two really different types. The two types of lions we're looking at are preferred stocks and common stocks.

"What's the difference?," you ask.

Remember, regardless of which type of stock you buy, purchasing stock makes you a part owner, or shareholder, of a company.

Let's Begin With Preferred Stock.

Companies that sell preferred stock are actually offering a blend of a more aggressive investment (stock) and a more conservative one (bond). This combination means that the price of preferred stock does not fluctuate as much as the price of common stock. That's why many risk-averse investors favor preferred stock.

Another advantage to owning preferred stock is that it almost always pays a dividend to shareholders.

Companies pay dividends to preferred stock shareholders before they pay dividends to common-stock shareholders.

Dividends accumulate if the company's board of directors decides to put a freeze on divvying up profits because it doesn't have the financial resources.

If the company goes bankrupt, preferred stockholders have a claim to any assets ahead of common stockholders.

On the other hand, preferred stockholders don't have any voting rights. To many investors, this doesn't really matter, but if, as an owner, you are passionate about management decisions at the company, you may want the right to vote. If so, then preferred stock is not for you.

Now Let's Talk About Common Stock.

Common stock, which is sold by most companies, is the only "pure" form of stock in the market. It's what people are talking about when they just mention "stocks." Because common stock has the potential for greater returns, investors buy it more often than they do preferred stock.

Common stock represents an equity ownership in the company and entitles shareholders the right to vote on management issues at the annual shareholder's meeting.

Common stockholders may, or may not, receive dividends, depending on management's decision about distributing profits.

Many beginning investors believe that preferred stock is better than common stock, but that's not necessarily the case. Your decision to purchase one over the other depends upon your financial goals, your tolerance for risk, and your interest in voting rights in the company.

Because most investors are interested in price appreciation, they usually purchase common stock. You get more "bang for your buck." It's that simple -- and so is our goal for you: to get the returns you need to fund your dreams. That's why we wrote this guide.

So, from this point on, whenever we refer to "stock," we mean common stock. A little later, we'll begin to learn about specific kinds of stocks that are best for you, such as growth-producing or income-producing.

Right now, though, you're ready to step a little further along the trail.

How Do You Make Money Investing in Stock?

There are two ways to earn money when you invest in stock: price appreciation and dividends.

If the company you invest in does well and makes money, its stock becomes attractive to own, and soon more investors will want to own some of the company that you own. That's when supply and demand works in your favor. The greater the demand, the more the price is driven up. The price moving up (because more people are buying the stock) is known as price appreciation -- your stock increases in value. You'll realize a profit, or gain, when you sell stock that has appreciated.

Say you buy stock for $10 a share, and it grows, or appreciates, to $15. Smart you! You earned $5, and the value of your share of stock increased, or appreciated, by 50%. The flip side of that is price depreciation, which is another way of saying that the price of a stock went down.

In addition to the potential price appreciation, or attractiveness, of your stock in the public's eye, you can also earn a dividend when you own stock.

Distributing dividend payments is another way for a company to share its profit with you. This means that each quarter the company pays you a certain amount of money for each share of stock you own. Usually dividend payments are much smaller than the price of the stock. For example, a company whose stock price is $15 per share might pay a dividend of 4 cents per share each quarter.

Many times, dividends come at the expense of greater price appreciation, because the company is distributing its profits to shareholders rather than reinvesting these profits back into the growth of the company. However, companies that pay dividends can be very attractive to investors, because they offer a steady stream of income. Whichever you pick -- current income (dividends) or longer-term growth (price appreciation) -- as your priority depends on what you need.

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