Common stocks: what they are and why you should care

Investing in the stock market can feel confusing at first, especially with all the new terms and numbers. But common stocks are often a great place to begin when you’re looking to grow your wealth, as owning them gives you partial ownership in a company, allowing you to share in its success.

In this guide, we’ll break down what common stocks are, how they work, and how they compare to preferred stocks. We’ll also go over how you can start investing in them, so you can see how common stocks might fit into your financial plans.

What are common stocks?

Common stocks are a type of security that represents ownership in a corporation. When you purchase common stock, you're essentially buying a small piece of that company, making you a shareholder. As a shareholder, you have a claim on part of the company's assets and earnings.

The value of common stock can rise or fall based on the company's performance and market conditions, offering investors the potential for capital gains as the stock price appreciates. In addition to financial benefits, owning common stock often grants voting rights, allowing shareholders to influence important corporate decisions.

Common stocks are widely traded on stock exchanges and are a fundamental component of investment portfolios due to their potential for growth and income.

Common stock features

Common stocks come with features that make them a unique and appealing investment option.

Here are the five main characteristics of common stocks:

1. Ownership and voting rights

Owning common stock means having a stake in a company. This ownership usually comes with the right to vote on important matters, like electing the board of directors or making decisions that could impact the company's future.

2. Dividends

Common stockholders can receive dividends, which are a portion of the company's profits distributed to shareholders. However, unlike preferred stocks, dividends on common stocks are not guaranteed and can fluctuate based on the company's earnings and decisions by its board of directors.

3. Capital appreciation

One of the most attractive features of common stocks is their potential for capital appreciation. As the company grows and becomes more profitable, the value of your shares can increase, allowing you to sell them at a higher price than you paid.

4. Residual claims on assets

If a company is liquidated, common stockholders have a claim on the company's assets after all debts and obligations have been settled. However, this claim is last in line, behind creditors and preferred shareholders, which adds a layer of risk.

5. Liquidity

Common stocks are highly liquid, meaning they can be easily bought and sold on stock exchanges. This liquidity makes them a flexible investment, allowing you to quickly enter or exit positions based on market conditions.

Common stocks vs. preferred stocks

When investing in stocks, it's essential to understand the differences between common stocks and preferred stocks. While both represent ownership in a company, they come with some distinct differences.

Ownership and voting rights

• Common stocks. Common stockholders typically have voting rights, giving them a say in important company decisions, such as electing the board of directors and approving major corporate policies.
• Preferred stocks. Generally, preferred stockholders do not have voting rights. Their role is more focused on the financial benefits of the stock rather than having a voice in company governance.

Dividends

• Common stocks. Dividends are not guaranteed and can vary based on the company's profitability and the decisions made by its board of directors. If a company performs well, dividends may increase, but during more challenging times, they may be reduced or skipped altogether.
• Preferred stocks. Typically come with a fixed dividend rate, providing a more predictable income stream. Additionally, preferred stockholders receive their dividends before any dividends are paid to common stockholders.

Claims on assets

• Common stocks. In the event of liquidation, common stockholders have the last claim on the company's assets after all debts, bonds, and preferred stockholders have been paid. This makes common stocks inherently riskier, though they also offer greater potential rewards.
• Preferred stocks. Preferred stockholders have a higher claim on assets than common stockholders. If the company faces liquidation, they are paid out before common stockholders but still after debt holders and bondholders.

Convertibility

• Common stocks. These are not convertible into any other type of security.
• Preferred stocks. Some preferred stocks have a convertibility feature, allowing holders to convert their shares into a predetermined number of common shares, which can be beneficial if the company's common stock appreciates significantly.

Price stability

• Common stocks. Prices are generally more volatile, responding directly to the company's performance and broader market conditions. This volatility can lead to significant gains but also poses the risk of substantial losses.
• Preferred stocks. Typically less volatile, preferred stocks offer more stability due to their fixed dividend payments and lower sensitivity to market conditions.

Market participation and growth potential

• Common stocks. Shareholders can benefit directly from the company's growth. If the company performs well and its profits increase, the value of common stocks can rise significantly. This means that in addition to receiving dividends (when declared), common stockholders can see their investments grow through capital appreciation.
• Preferred stocks. Preferred stocks focus more on providing a steady income through fixed dividends rather than benefiting from the company's growth. So, while preferred shareholders receive dividends, their returns are generally capped by the fixed dividend rate.

Why consider investing in common stocks?

Investing in common stocks can potentially be an effective way to build wealth over time.  Here are some of the main reasons why common stocks can be considered a central part of your investment strategy:

Potential for high returns

Historically, common stocks have offered higher returns than asset classes like bonds or savings accounts. If you invest in the right companies, you can benefit from their growth and increase your wealth significantly over the long term. This potential for capital appreciation is one of the main reasons investors turn to common stocks.

Dividend income

Many companies pay dividends to their shareholders, providing a regular income stream in addition to potential capital gains. While dividends from common stocks are not guaranteed and can fluctuate based on the company's performance, they can be a valuable source of income, particularly for long-term investors who reinvest their dividends.

Ownership and voting rights

When you purchase common stocks, you gain a share of ownership in the company. This ownership typically comes with voting rights, allowing you to have a say in major corporate decisions, such as electing the board of directors or approving mergers and acquisitions. This can give you a sense of involvement and influence over the direction of the company.

Liquidity

Common stocks are highly liquid assets, meaning they can be bought and sold quickly on the stock market. This liquidity gives you flexibility, allowing you to easily adjust your portfolio in response to market conditions or changes in your investment goals.

Diversification opportunities

The stock market offers a wide range of companies across various sectors and industries. If you invest in a diverse set of common stocks, you can spread your risk and reduce the impact of a poor-performing stock on your overall portfolio. Diversification is a fundamental principle of sound investing, and common stocks provide an effective way to achieve it.

Inflation hedge

Over time, inflation erodes the purchasing power of money. Common stocks, however, have the potential to outpace inflation by providing returns that exceed the rate of inflation. This makes them a valuable tool for preserving and growing wealth in the long run.

Participation in economic growth

Investing in common stocks allows you to participate in the growth of the economy. As companies innovate and expand, their stock prices tend to rise, reflecting the overall economic progress. When you hold common stocks, you can benefit from the broader economic trends that drive corporate profitability.

Flexibility in investment strategies

Whether you're a growth investor looking for companies with high potential or a value investor seeking undervalued stocks, common stocks provide opportunities to tailor your investment strategy to your personal preferences and financial goals.