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So, what is a preferred stock?
Imagine stocks and bonds got together and had a baby. That baby would be a preferred stock. Preferred stocks have features of both stocks and bonds. They are similar to bonds because they generally pay a fixed rate. For example. Let’s pretend a company issues a preferred stock. That preferred is going to cost the investor 25 dollars – 25 dollars is the most common starting price for preferred stocks - and let’s assume that the company declares that this particular preferred will pay 1 dollar in dividends each year.

That means that this preferred stock will have a 4% dividend yield. A dividend yield is calculated by dividing the annual dividend by the price of the stock. So here it would 1 divided by 25. Now if you are familiar with bonds, you will see that this is a very similar concept. If you’re not comfortable with bonds, watch our what are bonds video to get an introduction to them.

So functionally the dividends of preferred work very similar to bonds. But they are also similar to stocks in that owning preferred shares also represent ownership in the company just like stocks do. Preferred shares have an advantage over common shares in that they are higher up in the pecking order. What I mean is that if the company ever went bankrupt, the assets are sold off and the investors get paid off. First, the bond investors get paid, then preferred investors get paid and if there is anything else left, common shares would get something back. On the flip side – a disadvantage of owning preferred is that a preferred stockholder doesn’t get any voting rights like common shareholders do.

This brings is to three risks to consider when investing in preferred stock.

1st if a company every faced financial trouble, they are going to cut the preferred shareholder dividend before they will stop paying bond shareholders. Now some preferred shareholder would have a right to get to even if dividends are skipped. This a called a cumulative preferred. All it means is that if you own a cumulative preferred and the company doesn’t pay a dividend when they are supposed to, they must make up that dividend before they can pay anything to common stock shareholders.

2nd risk is low trading volume. Preferred are often not the most popular investments so if you ever want to buy or sell a lot of shares, you could have trouble

3rd is rising interest rates. This is important because if you’ve heard any news about raising rates lately, this is a real possibility in today’s environment. Rising rates hurt preferred because once again the dividend is fixed so you paid 25 dollars for a 4% yield in our example, but let’s image rates rose that now it was easy to buy something that paid a 6% yield. Many people are likely to sell their preferred and reinvest it in something that pays a “better” dividend.

At the start of the video, I mentioned that there is an important consideration when it comes to preferred investing. And that is to be aware of the types of companies that issue preferred. The majority of preferred come from companies in the financial sector. This is important to know because if you are trying to build a portfolio, and you allocate a portion of your portfolio to preferred, and then some to the financial sector, you need to be aware that many of the risks of investing in financial companies will hold true for your preferred investments.

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DISCLAIMER: I am not a financial advisor. These videos are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.

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