Preferred Stock Is Not Preferred

How many times have you heard this:

Preferred stock is the best of both worlds: The upside of common stock and the protection of bonds?

Not so fast.

According to a study by Guohua Li, Ph.D and Edward O'Neal, Ph.D., principals of SLCG, Inc., this view of preferred stock is "overly simplistic."

From July, 2007 to March, 2009, the S&P Preferred Stock Index fell by almost 70%, while common stocks fared relatively better, losing 50%. The bond markets had positive returns.

There is nothing "preferred" about those results.

When things are rosy, common stock holders are well rewarded. Holders of preferred stock receive far more modest returns. So much for the upside. What about the downside?

There is a reason for the much touted higher yield of preferred stocks. They are much riskier than bonds. In a down market, the shares of preferred and common stock have to descend to zero before the bond holders are affected at all.

Contrary to traditional wisdom, it appears that holders of preferred stock get the worst of both worlds. Preferred stock is riskier than bonds, but it doesn't have the same upside as common stock.

The bad news doesn't stop there.

Issuers of preferred stock are primarily financial institutions. Holders of preferred stock typically are not aware their stock is concentrated in this risky and volatile sector.

Preferred stock is also costlier to trade because it is significantly less liquid than common stock.

If your broker has recommended preferred stock for your portfolio, you need to be aware of these risks.

There is a more fundamental issue here. Why are you using a broker?

Dan Solin is the author of The Smartest Retirement Book You'll Ever Read.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

 

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Comments

[ThirdPartyTime]

One final question, isn't the term "markets regard" of little or no efficacy anymore? Markets regarded bank of America as a $50 stock last year, and CDO's as wonderful investments. The market also regarded Ford as a dead company, when it is now likely that it will be profitable for the foreseeable future. The markets also regarded California municipal bonds as below AAA this year, forcing prices down, when anyone with an ounce of experience understands that there is 0% chance of default, even if California residents have to pay the tax to cover the interest. In other words, who really cares what the markets regard, as over the past 100 years they are only correct about the obvious and wrong more often than not concerning anything speculative? When it is true that if you purchase municipal bonds in your state of residence and federal long term and short term treasuries over your working life, you will likely outperform any "properly" weighted portfolio in the stock market with almost no risk and lower taxes, why even talk about what the so called "markets" that ran the world into a ditch regard? I'm sorry for the tone, but any term containing the term "markets" is inherently speculative and in most cases, dead wrong.

[BigGuy]

Your internet ad for your new book is GREAT.

[BigGuy]

Coming up from the bottom in October "08, preferreds of Morgan Stanley outperformed the common. Coming up from the bottom of March "09, preferreds of regional bank stocks outperformed the common stocks.

Preferreds are usually less risky in flat markets and less rewarding in bull markets, but can provide higher returns because of the higher dividends. During panics, like we had, they underperform.

As to why have a full service broker -- because a full service broker can help prevent you from doing anything really foolhardy. I certainly did that when I was a broker, explaining to my clients that I earned my commissions a lot of the time when I didn't do business with them -- when they paid me by buying or selling a stock at full commission -- they were also paying me for when I convinced them NOT to buy the story stock they just heard about and paying me for when I convinced them NOT to sell a blue chip stock that was rising with the market.

With regard to whether full service brokers are beneficial for investors, Dalbar's studies
http://www.dalbar.com/content/showpage.asp?page=is1
consistently find that individual's investment performance with broker assisted load funds is superior to individual's investment performance in no-load funds without any broker assistance. That's not comparing mutual fund performance, but comparing the aggregated performance of individual accounts, load fund versus no-load fund accounts, over time. The logical explanation is that the brokers earn their commissions.

[Dan Solin - Huffpost Blogger]

Thanks for your compliment about the trailer for the book.

I can't agree with your interpretation of the Dalbar studies. They show that investors substantially underperformed the indexes over all periods measured.

Check out this study:

www.people.hbs.edu/ptufano/bbenefits_Nov2004.pdf

The authors conclude that mutual funds selected by brokers and advisors underperformed both the indexes and the funds selected by investors on their own.They also found that brokers and advisors did not help correct bad investor behavior or provide superior asset allocation or help clients find funds that are lower cost.

The conclusion is inescapable: Investors should not use market beating brokers or advisors.

[BigGuy]

The Dalbar studies between 1990 and 2001 inclusive -- the years that I worked as a broker -- that compared the performance of individual accounts, load fund accounts at full service firms, versus individual no-load fund accounts at discounters or directly at the funds, consistently showed that, aggregated together, the average individual accounts in load funds at the full service firms, outperformed the average individual accounts invested in no-load funds.

Individuals, investing on their own or with full service brokerage assistance, tend to underperform the indices, as do most money managers. Individuals doing everything on their own though usually do even worse than individuals who use full service brokers.

Most studies look at mutual fund performance over time, not individual brokerage accounts. Doing so usually makes the funds look better than they actually are.

[ThirdPartyTime]

Dan: What about the Preferred stock in the REIT sector? When I saw shares of REIT's drop precipitously in 2008, I bought some preffered stock of REITs with decent balance sheets and no Common stock dividend cuts with a par of $25 for nearly half that amount. I understand your point and would always steer clear of Preferred stock and Hybrid Preferreds of banks and financial institutions. I also understand that there is little upside in terms of share appreciation, but I feel as if REIT Preferreds and regulated Utility company Preferreds are good places to park money and earn above Money Market rates with little risk if I am willing to forgo the upside of common stock in return for a guaranteed payment. Am I off base?

[Dan Solin - Huffpost Blogger]

REIT Preferreds and regulated Utility company Preferreds may or may not be good investments. However, here is an inviolate rule:

When a security pays "above Money Market rates", it is an indication that the markets regard the security as having a higher risk than Money Market funds.

Also a "guarantee" is only as good as the entity standing behind it.

[ThirdPartyTime]

Thank you very much for the response Dan. I am currently in the process of deciding whether or not to sell off all the shares of companies I began buying like mad early in the year when the Dow was near 6500 and purchasing a schwab no-load mid-cap index mutual fund, a large-cap index mutual fund, an international index mutual fund, a domestic bond fund, and international bond fund, and using cash to buy individual treasury strips and individual corporate bonds to weight the portfolio 60-60 equity-fixed. It's a tough decision as I have diluted myself into believing that I can pick stocks, and have actualy done pretty well because I normally only buy companies with long term dividend history and growth, but time constraints limit my ability to reasearch individual stocks these days. Any thoughts?