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Preferred Stock & Common Stock: What's the Difference?

Not sure which way to go? Learn the difference between common stocks and preferred stocks before making your decision.

If you don't know much about investing, the ins and outs can seem complicated. But once you break everything down, it becomes much easier, and the first question for the novice investor is likely "What can I invest in?" Let's start at the absolute most basic, and the most prominent of the investment classes: 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.

When you buy stock, you become part owner of the company -- maybe only a very small part, but still an owner. In a sense, you're finally a business owner just like you've always dreamed!

Make sure, then, that you've done plenty of research into a company if you plan on investing or trading their shares. We've all seen terrifically run businesses and atrociously run businesses in our time, but a company's outlook isn't always as good as they're trying to make it seem. Give as in depth a look as you can into their financial situation and forecasts for the future; there's no such thing as too thorough when it comes to figuring out the right stock to buy.

We can also use "stocks" as a broader categorization of two specific types of stocks you have the opportunity to invest in. These are preferred stocks and common stocks. Each brings its own unique pros and cons, and not every company offers both. You'll have to decide for yourself, should you even have the option, which to choose.

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

What is a Preferred Stock?

Preferred shareholders, true to the name, are given a higher priority than common shareholders in a number of regards. For example, companies pay dividends to preferred stock shareholders before they pay dividends to common-stock shareholders.

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 while the price of preferred stock can appreciate, it doesn't 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. While it's possible to succeed with stocks that don't offer dividends, they can really come in handy - especially if the company isn't doing so well.

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 also have a claim to any assets ahead of common stockholders.

On the other hand, preferred stockholders don't usually 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.

What is a 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. And should the company go bankrupt, these shareholders have to wait until preferred ones claim their assets.

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. It's higher risk, but higher reward too. You get more "bang for your buck."

From this point on, whenever we refer to "stock," we mean common stock. It is, after all, much more commonly purchased. 

How to Make Money in Stocks

Investing is seen by many in the world of the stock market as much as a game as a way to make money. But even if it's a game, it'd be nice to turn a profit. It's not easy, and it can take time for an investment to pay off, if it ever does. But it's possible.

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

Price Appreciation: Stocks on the Rise

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. Nice work! 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. With depreciation, you may lose money if you worry the stock will fall even further and sell it, or you could be holding onto it for a while, waiting for it to appreciate.

Dividend Stocks

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 as your priority -- current income (dividends) or longer-term growth (price appreciation) -- depends on what you need.

Stocks, Bonds & Cash

Bonds are a different asset from stocks, but it's important for you to know that they're out there as a different investing option. 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 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.

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.