Risk and Earnings Return

Risk and return are two basic measurements in investment and financing used by investors and borrowers. The higher the return to expect, the higher the risk to bear. Out of a company's stakeholders, common shareholders have the most earnings potential. After a company has first paid out borrowing interest to creditors and preferred dividends to preferred shareholders, the remaining earnings all belong to common shareholders. On the other hand, common shareholders bear the most risk. If the company has nothing left after paying creditors and preferred shareholders, common shareholders will receive nothing.

Risk and Liquidation Claims

Common stock is also riskier than preferred stock when it comes to liquidation claims. Preferred shareholders are behind creditors but ahead of common shareholders in receiving liquidated assets. Moreover, some companies allow preferred shareholders to further participate in the distribution of liquidation proceeds beyond their initial recovery of the face value amount of their preferred stocks, which would put common shareholders in an even more risky situation.

Risk and Voting Rights

Similar to risk and return, rights come with responsibilities. In terms of shareholders voting rights, preferred shareholders are normally given no voting rights leaving a company's management solely in the hands of common shareholders. With total control of business operations, common shareholders must assume the most responsibilities and thus bear the most risk.

Risk and Price Violatility

Common stocks are seen as risky mostly because of their potential price fluctuation. Preferred stocks are also traded on a stock exchange, but usually have little price movement from one day to the next. In fact, as semi-fixed-income securities, prices of preferred stocks often respond to changing market interest rate to some extent. But the real price volatility exists in the trading of common stocks, which makes investing in common stocks riskier than holding preferred stocks.

The Choice

Despite their inherent higher risk, common stocks remain a primary investment venue, especially for average investors. In fact, coupled with tax considerations, institutional investors are most likely to invest in preferred stocks, as 70 percent of the dividends companies receive are exempt from corporate income taxes. Choose between common stocks and preferred stocks based on investors different investment goals and strategies, as they offer different levels of risks and returns, most noticeably price appreciation versus steady income. Data from Contemporary Financial Management shows that over time, common stocks have returns of 6.1 percent higher on average than securities returning mostly fixed income.