21 January 2024 | By INDIE
Preferred stock is an important type of security for investors. It offers desirable qualities of both common stock and bonds. As with common stock, preferred shares represent partial ownership in a company. However, they differ from common stock in terms of dividend and liquidation rights.
What is preferred stock?
Preferred stock is a class of ownership in a company that has a higher claim on the company’s assets and earnings than common stock. Preferred stock is considered a hybrid security that exhibits characteristics of both bonds and common stock. Like bonds, preferred shares offer a fixed dividend that must be paid out before any dividends to common shareholders. However, unlike bonds, preferred shares do not have a maturity date and the company does not have an obligation to repay the initial investment, called the liquidation preference.
From the investor's perspective, preferred stock provides a balance between risk and return. Compared to common stock, preferred shares have less upside potential for capital appreciation but are given priority over common stock in receiving their stated dividend and liquidation proceeds. This makes them less risky than common stock. Compared to bonds, preferred stock pays dividends that are not fixed but depend on the company's earnings. However, preferred stockholders do not have the security of repayment of par value that bondholders have.
How do I start investing in stocks?
If you’re wondering, how do I start investing in stocks, here’s a quick guide to help you get your journey in the stock market started.
Open a demat and trading account: Choose a reputable broker such as IndusInd Bank’s INDIE that offers low brokerage and good research tools. Make sure to read all terms and conditions carefully regarding account opening requirements, brokerage charges, taxes, etc.
Fund your account: Transfer money from your bank to the trading account. Most brokers allow funding via UPI, net banking, IMPS, or RTGS. Remember the T+2 settlement cycle for delivery trades.
Start with paper trading: Practice trading on a 'virtual' trading account to understand placing orders and squaring off positions without real money risk. This will help you get familiar with the platform.
Decide your goals and risk profile: Actively or passively trading? Long term or intraday? Define your investment goals whether wealth creation, income, or timing the market. Understand your risk tolerance for losses.
Choose stocks carefully: You can start with 15-20 large-cap stocks from sectors like FMCG, pharma, IT, and banking that have steady growth. Technical and fundamental analysis helps filter opportunities.
Diversify your portfolio: It’s not recommended to allocate more than 10% to 15% of your capital to a single stock. Maintain sector-wise allocation as per their weight in the overall market.
Monitor and review periodically: Set performance benchmarks and watch corporate developments. Trim or add to existing positions based on changes in business fundamentals or market conditions.
Types of Preferred Stock
Here are the main types of preferred shares:
Cumulative preferred stock: When dividends are missed, the unpaid amounts accumulate with interest and have to be paid before any dividends to common stock shareholders. Cumulative preferred stock is less risky than non-cumulative due to this feature.
Non-cumulative preferred stock: Missed dividends in any year are forfeited permanently and do not accumulate. Non-cumulative preferred stock is riskier as the company has no obligation to catch up on past year dividends.
Participating preferred stock: In addition to their fixed dividend, these preferred shares may receive extra dividends if the company pays higher dividends to common shareholders. So, they carry more upside potential.
Convertible preferred stock: Holders can convert these preferred shares into a fixed number of common shares after some time or when the stock price reaches a pre-determined level. This provides an opportunity to benefit from rising share prices.
Wrapping up
While less risky than common shares, preferred stock offers higher yields than bonds of similar credit quality due to their equity features and relative illiquidity compared to corporate bonds. Understanding the properties and risks of each type is vital for investors evaluating preferred shares for their portfolio.
