The goal of every investor is to maximize profit while minimizing risk. If you think about it we really aren’t that different then our caveman ancestors who weighed the risk of hunting large game against having enough meat to feed everyone for a few days.
Stocks definitely have higher income potential then bonds but are also riskier and common stock carries heavier risk then preferred stock. With common stock when the company does well the value of the stock increases. With bonds it doesn’t matter if the company increases in value because the bonds pay a pre-determined interest rate.
Preferred stock is a sort of hybrid of bonds and common stock. They can have the high income potential of stocks but also have a dividend amount that, although not guaranteed, must be paid before the company can pay the common stock holders a dividend. Furthermore, preferred stocks are right below bonds and above common stock for receiving funds leftover if a company goes through bankruptcy and has to liquidate.
When the company you have invested in is losing money your preferred stock may cease paying dividends but your chances of not getting dividends are less then those of the common stockholder. Common stock holders during a downturn risk, not only, not receiving dividends but at a time when selling the stock would result in a loss.
Bond holders always know what they will be getting as a monetary return but also have to face the fact that their principle is tied up for a set period and when the opportune time to sell and invest in stock arrives the bonds may be only sellable at a loss.
Common stock comes as a one size fits all instrument but preferred stocks can come in a variety of forms some of the most popular of which are Callable, Convertible, , and Cumulative. The majority of preferred stock is callable (redeemable) and in the prospectus the time at which the stock can be redeemed and the price it can be redeemed at is laid out. Convertible refers to a preferred stock being eligible to be converted into common stock. Likewise the prospectus will also specify the time and price for the stocks conversion. Cumulative refers to preferred stocks whose dividends are considered as a debt. Even when the company is doing poorly and cannot afford to pay the preferred stock holders those dividends are still owed and must be paid not only before common stockholders but also before noncumulative preferred stockholders are paid.
A less common but important form of preferred stock is Participating Preferred. Participating Preferred stock has the potential to earn more then the fixed rate agreed upon, if certain conditions laid out in the prospectus are met.
As one can see, with bonds there is considerable safety but low earning potential and with preferred stocks there is some safety, there is flexibility and more earning potential then bonds. Common stocks have the greatest earning potential but no safety or flexibility. With common stock it’s one size fits all and hope for the best which is a dangerous way to invest your hard earned cash.