Navexa Blog

Common stock versus preferred stock — not sure where to start? In this post, we explain these different types of stocks, what they mean for shareholders, and the key qualities of common stock as opposed to preferred stock, and vice versa.

Not all stocks are created equal. And we don’t just mean that some stocks perform better than other stocks.

Rather, there’s two distinct types trading on the open market: Common and preferred.

The first you’re probably already familiar with. The second, maybe not so much.

Common and preferred stock offer shareholders very different things — from their pricing and dividend payments, through to the privileges you’re entitled to as a shareholder of each.

Below, we explain common vs preferred stock, which is better, which is safer and more.

Common: The Stocks Most Shareholders Buy

If you’ve bought shares before, chances are you probably bought common stock. Most of the time, common stock is what we talk about investing in. Most of the world’s major markets consist of common stock, as opposed to preferred.

The definition of a stock is this: A security representing a share of ownership in a company.

When you own common shares, you own a percentage of the company or fund’s assets and profits. This is the idea upon which most stock trading rests — that buying shares in the right companies exposes your money to their success.

By owning common stock, shareholders are aiming for one — or both — of two things. First, they’re looking to increase the value of their shares via gains to the stock’s share price. If a stock rises 100%, for example, shareholders who bought before that gain could double their money.

Second, investors can benefit from holding common stock through dividends the company pays to its shareholders. In other words, you can get paid to own common stock shares — if the company’s board of directors chooses to pay a dividend.

Dividend income is one of the key differences between common vs preferred stock.

There’s another crucial benefit to owning common shares: Voting rights. As a shareholder in a company, you get voting rights on some of that company’s corporate decisions. Preferred shares do not confer the shareholder these same voting rights.

Preferred Shares: More Like Owning A Bond Than Shares

Preferred shares, while they might sound similar to common shares, are actually a very different form of investment.

They function more like a bond.

A bond is a fixed income instrument. When you buy a bond, you’re essentially making a loan to a government or company, who use them to raise money.

An investor buys a bond because it entitles them to receive a fixed income for an agreed period, at the end of which the issuer will buy it back.

Preferred shares functions in a similar way. You buy a ‘preferreds’ not to profit from a company’s rising share price (or have any voting rights as a shareholder), but to receive a fixed income for an agreed period. Some preferreds don’t ever expire — you can buy them, collect the income and never have to re-sell them to the issuer.

So, it’s a significantly different form of investment. Why do we refer to it as preferred? The answer relates to the income you collect. Preferred stockholders are entitled to collect any income the company decides to distribute before common stockholders.

When it comes to dividend distributions, there’s a hierarchy. Bonds are first in line to receive income, then preferred shareholders, then common shareholders. While owning common shares exposes you to a company’s capital gains, it doesn’t guarantee that you’ll receive a dividend — or that each dividend you receive will be the same amount.

Owning preferreds doesn’t expose you to the company’s capital gains, but it does ensure that you’ll receive a share of the profits as a dividend before common stockholders (but after bond holders).

And, you don’t receive voting rights. While owners of common stocks get voting rights in certain situations, preferred stocks do not offer this benefit.

Which Is Better, Common Or Preferred Shares?

Like many questions about investing, whether common or preferred is ‘better’ depends largely on the individual investor’s objectives and preferences.

Consider the key differences.

Common Stock vs Preferred Stock: Key Differences

• Preferreds grant shareholders the right to receive dividend income from the company before common shareholders.
  
  
• Common shares grant shareholders the right to vote on matters like who joins the board of directors, operational and structural changes and issues affecting the shareholders themselves like mergers, acquisitions and stock splits. Preferred shareholders do not gain any such voting privileges.
  
  
• If a company is forced to close and liquidate its assets, preferred stockholders are entitled to payment before common stockholders.

So in assessing which is ‘better’, you should consider what your priorities and preferences dictate. If you’re looking to invest in a company you whose share price you think could rise 10-fold in the next five years, you might prefer to go for common shares, since this will allow you to capture your share of any capital gain.

But, if you’re looking to buy a stock and collect income from it over several decades, you might consider buying preferred stock (if, of course, the company offers preferred stock — many do not).

Common Stock vs Preferred Stock: Which Is Safer?

While preferred shares are similar in ways to a bond, they’re still shares. This means that its value — and the dividends it might generate — can fluctuate.

According to this professional advisor, ‘nothing is guaranteed with preferred stocks’. 

While you are entitled to receive dividends before common shareholders when you own preferreds, this doesn’t mean you’re guaranteed to receive them.

It’s possible that a company will choose not to pay a dividend to common stockholders but still pay one to preferred stockholders. So in that sense, preferreds could give you a better chance of collecting income from your investment.

One thing to note is that some preferred stocks are classified ‘cumulative’ preferred. This means that if a company misses a dividend payment, it’s obliged to pay the arrears in the future — before paying dividends to common stockholders.

Preferred stocks, like common stocks, are liable to rise and fall. See the chart below showing a preferred stock ETF (in blue) relative to a common stocks fund over five years.

If the company goes out of business, preferred stockholders will receive payment before common stockholders, but after creditors and bond holders.

So by some measure, preferreds could be regarded as relatively more safe compared with common shares. But all investments, of course, carry risk. You should always do your own research and seek a professional opinion before risking your money. 

Why Would A Company Issue Preferred Stock Vs Common Stock?

Preferred stock offerings are relatively rare in the stock market. There’s two main types of organizations that tend to offer them; Financial companies like banks, and real estate investment trusts, or REITs.

Businesses liked these might choose to issue preferred stock because it counts not as a liability on their balance sheet, but equity instead. That lets the business raise funds without increasing its debt-to-equity ratio.

Preferred stock also grants less control of a company to outside investors — something a business may prefer than offering common stock.

What Is The Downside Of Preferred Stock?

If the benefits of owning preferred stock as a shareholder are better privileges when it comes to dividend income and payment in the event of bankruptcy or liquidation, then the downsides are these:

1.   You don’t get any say in corporate decisions like you could get by owning common stock. This means you’re more of a passenger on the company’s journey than an active shareholder who can influence its direction or strategy.

2.   You don’t get any exposure to the stock’s potential capital gains. If your own preferred stock in a bank that produces a 100% price gain, you won’t benefit as a preferred stockholder. Although, you may indirectly enjoy a share of those profits in the form of an increased dividend payment.

Common Stockholders vs Preferred Stockholders

The differences between common stock and preferred stock are simple.

Common stock — which accounts for the majority of stock available on the market — gives you the standard exposure and rights you’re probably used to as a shareholder. You can grow (or lose) your capital and collect dividend income by owning common stock.

Common stockholders are investors who have the right to profit from rising stock prices, collect income and have a say in corporate decisions. But, they are the last in line for dividends and bankruptcy payouts.

Preferred stock is far more rare than common stock. Only certain companies — generally financials and REITs — offer this bond-like type of stock.

Preferred stockholders don’t get exposure to capital appreciation. Rather, they are ahead of common stockholders in the income and bankruptcy payout hierachy.

Earning Dividends From Common Stock Or Preferred Stock? You Must Do This.

Now you know the main differences between common stock and preferred stock.

But, did you know that many investors fail to properly track and account for their dividend income? They look at their capital gains and treat their portfolio’s income separately. But, the fact is, your dividend income has a potentially huge impact on your overall returns and performance.

With the Navexa portfolio tracker, you can easily track your dividend income.

Here’s an example of our dividends reporting, showing you how different holdings generate income year to year:

Whether you’re collecting income from common stock or preferred stock — in fact, especially if you’re a preferred stockholder — you need to be able to report correctly on that income at tax time.

That’s why we’ve created an automated portfolio income tax report in Navexa: 

 If you want to improve your dividend income tracking and reporting, take a free trial of Navexa today.

Trading the stock market is a complex and ever-changing challenge. Here are seven common trading strategies investors use to navigate it.  

Do you consider yourself an investor, or a trader? If you’re the type who prefers to buy and sell shares in the stock market often, instead of holding onto an investment perhaps for several years at a time, you’d probably be considered a stock trader.

You may have heard the terms ‘passive’ and ‘active’ investing.

Passive investing is generally long-term investing. You might research and value a stock, invest in some of its shares, and leave that investment alone for many years to let it appreciate in value.

Active investing is the opposite.

Active investing is the domain of the trader, as opposed to the investor.

Traders don’t look for long-term investments. Rather, they buy and sell stocks with the objective of making a quick profit from short-term price movement.

Some traders may make hundreds or thousands of trades a day, aiming to cycle their capital between positions — often looking to profit from both upward and downward price movement.

In this post, we’re going to introduce some of the essential components of trading strategies, from some of the common terms and ideas to important factors every trader, indeed every investor, should be familiar with.

Then, we’ll cover seven commonly used stock trading strategies traders of many different kinds are using in the stock market today.

Essential Components Of Every Trading Strategy

Trading in the stock market — regardless of which trading strategy you choose — requires a significant amount of knowledge.

Even beginning traders should invest substantial effort into educating themselves on the processes and terminology of the market and the wide variety of assets trading on it.

Volume: Volume refers to the amount of shares being bought or sold in a given stock at a given time. Most stock charts will show you the volume relative to the price movement — often with a bar graphic displayed over the price movement line. Volume shows you how much money is changing hands for that asset in the market.

Liquidity: Liquidity relates directly to volume. The more shares are being exchanged in a stock, the easier it should be to find a buyer or seller to trade with. Low liquidity might mean it takes time to execute your trade — which could mean the price shifts while you wait.

Volatility: This is the extent to which the stock’s price moves up and down. If the share price moved between, say, $100 and $105 over a one-month period, you’d say it showed low volatility compared with another that moved between $5 and $50 in the same timeframe.

Float & Short Float: When you hear traders talk about the ‘float’, they’re referring to the number of shares available to the public to buy and sell. The float has an effect on a stock’s liquidity. The ‘short float’ refers to the number of available shares that have been borrowed for short selling (this is a key indicator of short interest).

Long and Short: You may have heard the phrase ‘going long’ or ‘going short’. These are stock market terms for betting on a stock rising or falling in price. A ‘long’ position is where you buy shares and aim to sell them at a higher price. A ‘short’ position is where you borrow shares and agree to sell them at a lower price, capturing the difference as profit.

Moving Average: Traders will use the moving average to determine a stock’s trend over a given time frame. Many charting tools will allow you to set and view a moving average line over the price movement. This allows you to ‘zoom out’ and get a different perspective on a stock from price alone.

Stop Loss: Traders and investors alike commonly use stop loss orders to protect their capital. When you enter a trade with your broker, you can set that order to automatically sell you out of part, or all, of your position when the stock falls to a given price. This can save you losing more capital on a losing trade. It can also result in being ‘stopped out’ of a good trade during temporary price drop.

Limit Order: The limit order works similarly to the stop loss order. But in this case, you enter the trade with the condition to buy shares at a certain price. Say you’re keen to buy 100 shares in Stock X, but you don’t want to pay the current price of $20, you can enter a limit order so that if the price comes down to $15 within a given time frame, your broker will try to buy you those 100 shares.

These are just some of the key terms you need to be familiar with when entering the stock market as a trader or investors.

Remember, all investing carries risk and it’s vital to educate yourself, seek advice and be clear about the risks to your capital when you enter the market.

Seven Commonly Used Stock Trading Strategies

Now that we’ve covered some of the basics above, let’s get into the actual trading strategies you can choose from when looking to make money in the stock market.

Day Trading: Fast, High Impact Buying & Selling

You’ve probably heard of day trading. Day trading is exactly what it sounds like — a style of trading where all the buying and selling occurs within a single trading day.

The idea with day trading is to use large amounts of capital — and often ‘leverage’ (money borrowed for trading) — to profit from intraday price movements in stocks.

Day trading depends heavily on technical analysis. In other words, interpreting stock charts to determine the likelihood of small price movements one way or another.

Day trading relies heavily on technical analysis. The day trader tries to predict a short-term price movement, and bet a large amount of capital on that movement with a view to closing out the trade that same day.

For example, a day trader might calculate Stock X is going to increase from $10 to $10.25 that day.

They might put $100,000 of their own money into that trade, plus another $200,000 of leverage (borrowed money from their broker). They’ll probably use a stop loss to protect against critical losses, too.

If that price move does play out, it’s only a 2.5% gain. But with the $300,000 they traded with, that’s a $7,500 profit (minus the leverage fee, of course). 

That’s day trading in a nutshell! Of course, the potential big rewards come with the equal amount of risk.

Day trading is an often-talked about trading strategy which, like all stock trading strategies, carries with it the risk of losing money.

Position Trading: Looking to Profit From Medium-Term Trend Prediction

While day trading hinges on making trades within a single day, and trying to leverage tiny price movements for big profits, position trading is a relatively slower trading strategy.

Position trading, or ‘trend trading’ is similar to day trading in that the position trader will use charts and technical analysis (ADD TA ABOVE!) to determine whether a stock or market is likely to move up or down.

The difference is that position traders don’t worry about trying to predict prices. Instead, they use an array of tools, calculations and indicators — the moving average being a major one — to determine the trend.

Once they’re satisfied that a stock is trending a certain way, they’ll enter a trade with a view to holding that position until the trend changes.

This could mean they hold a stock for weeks or months. It could also mean they exit with a 5% gain or a 50% return. To the position trader, the length of the investment and the price change don’t matter. What matters is the trend.

Whatever they’ve put their money in, the trend trader monitors the investment’s trend. As soon as they see a clear indication the trend is about to change, they exit the position. They’ll also commonly employ stop loss orders to protect their capital.

Generally speaking, position or trend trading becomes is a difficult trading strategy in highly volatile markets, since it’s more difficult to determine medium and long-term trends when prices are rising and falling dramatically.

Swing Trading: Buying & Selling Based On Changes In Market Sentiment

Day trading is by definition a very short-term trading strategy. Position, or trend, trading is a longer term approach.

Between day trading and position trading, sits the swing trading strategy. Swing trading isn’t about trends, nor tiny movements in price. Rather, the swing trader focuses on changes in market sentiment about particular stocks.

Moving average indicators are key to swing trading. That’s because they help the trader interpret how the market feels about a given stock. Remember, the stock market is largely a measure of how people feel about companies and businesses.

A swing trader employs a particular kind of moving average called the exponential moving average, or EMA. The EMA doesn’t only reflect the average of a stock’s price for a given period. It also factors in the latest data points for that stock.

These might include company announcements, market news or relevant current events that could impact its stock (consider the extent to which the COVID-19 pandemic impacted airline and tourism businesses, for instance).

By interpreting these data using the EMA, the swing trader, will try to determine where bullish (optimistic) market sentiment changes, or swings, to bearish (pessimistic) sentiment.

They’ll use that data to time their entry and exit points for a trade — going either long or short depending on the swing and looking to exit a position once they believe the sentiment is set to swing back.

News Trading: Predicting Market Reactions To Current Events

Many trading strategies have a lot in common with each other.

You could think of news trading as swing trading’s cousin. But rather than using technical analysis to determine when prices are likely to move up or down, the news trader monitors current events to predict how a market might react.

 Again, consider the airline example above. A news trader might interpret the breaking pandemic stories as a signal airline stocks are about to fall, and either place short trades to profit from the downside, or wait to buy shares after the fall. 

See the chart above for an example of how the Brexit news had an immediate impact on the Pound/Euro exchange rate.

News trading requires a lot of research and time. It’s a less exact trading strategy that carries its own unique risks.

Scalping: Aiming to Accumulate Many Quick, Small Gains

Scalping is similar to day trading and trend trading strategies. The scalper will look for quick opportunities to profit using a combination of technical analysis and maybe some trend following.

But, rather than wait for a trend to establish itself, or change, the scalping trading strategy dictates that you get out of every trade fast.

Rather than trading, say, one or two positions a day, you’d trade maybe five or 10, with the aim of gathering up a handful of small wins that amount to a solid return.

The image illustrates how a scalper might approach a trading position.

While there’s no overnight risk (as scalping is a type of day trading), this trading strategy does require discipline, focus, and a tolerance for stress.

Algorithmic Trading Strategy: The Way of Wall Street’s Elite

All the stock trading strategies above have one thing in common: The trader makes the decisions on what they’ll buy and sell, when, and for what reason.

But all those trading strategies can be augmented with another.

In algorithmic trading, the onus is on a piece of software to decide what you should trade.

Algorithmic trading — also called black box trading, or automated trading) involves a computer interpreting huge amounts of market data to determine the best way to trade the market on a given day.

The algorithm produces trading recommendations which you can either manually follow, or automate, depending on the system.

This type of trading relies heavily on the quality of the algorithm you use (and the talent of the people who create it — check out Motion Trader for an example of a very successful trading algorithm).

How To Learn Stock Trading Strategies And Get Started As A Trader

 The stock trading strategies we’ve outlined above are just a few of the main types in the market.

There’s many more — and more being created and refined all the time as markets and technologies evolve.

If you want to learn, you have a centuries worth of knowledge to draw on in the form of books, online courses, YouTube channels and more.

The best thing to do is to start learning, talk with other traders and seek to build your knowledge.

If you’re not investing already and are just starting out, you might want to consider this brilliant stock simulator where you can start testing your ideas without any risk to your capital.

However You Choose To Trade The Market, You Must Do This…

Whether you’re day trading, swing trading or an algorithmic trader, there’s one tool you should make sure you have for your journey: A dedicated portfolio tracker.

When we invest and trade, we often just focus on stock prices and returns. But, in reality, there’s many more factors that impact how much money we actually make (or lose) in the market.

That’s why you need to portfolio tracker that calculates your true, annualized performance for your portfolio and the holdings in it.

True performance is different from the simple ‘gain’ you’ll see in your trading account. It accounts for how long you’ve held a position, trading fees, currency gain, taxation and dividend income.

The portfolio tracker we run here at Navexa does all this (plus, you can generate a variety of reports, from calculating unrealized capital gains to taxable income, portfolio contributions, and many more).

Take a free trial of the Navexa portfolio tracker and see for yourself what your portfolio’s true performance really is.

For the everyday investor, the world of short selling can seem like a dark and mysterious art. Perhaps one of the least understood terms in it is the ‘short float’. In this article, we explain what short float means, how it fits into trading, and how some investors use it to find profitable trades.

What is a short float?

Like many jargon terms you encounter when you get into the investing world, the short float is an often misunderstood — but relatively easy to grasp — term.

In this post, we explain what a short float means, why it exists, and how understanding it applies to everyday investing.

Plus, we share some examples of how investors and traders use the short float when they’re researching and executing trades.

Breaking It Down: What Is A Stock’s Float?

In the context of investing, the ‘float’ refers to the number of a company’s shares that are available to the public at a given time.

See, not all a stock’s shares are available for the everyday investor to buy or sell.

Shares are generally divided up into restricted and unrestricted groups.

Restricted shares are those issues to directors, executives and corporate affiliates.

The rest are available to the market.

It’s these unrestricted shares that constitute a stock’s float.

It’s important to understand that the size of a stock’s float (in other words, the total number of shares available on the open market) can impact its volatility.

A smaller float could mean it’s more difficult to buy or sell shares.

You might think checking a stock’s ‘shares outstanding’ figure will give you an indication of its potential liquidity.

But, it’s important to understand that the float is different from shares outstanding.

While shares outstanding refers to the total number of shares a stock has (including restricted shares), the float refers only to those actually available for everyday investors to buy and sell.

Short Selling: A Brief Explanation

You might have heard the term ‘short selling’ when the Gamestop story was in the headlines in early 2021.

Short selling — or just ‘shorting’ for… well, short — is when you borrow shares from a stock broker and sell them to another investor for a given price.

You also agree that you will buy those shares back at a specific time.

If you borrowed $5,000 worth of shares in a company you thought was going to be trading 50% lower in three months — and your prediction proved correct — you’d be able to buy those shares back for $2,500, return them to your broker and pocket the other $2,500.

That’s shorting in a nutshell.

It’s a way to potentially profit from prices falling instead of rising.

It’s important to note that you can’t short sell shares you own.

You have to borrow them, sell them, buy them back and return them to make money from shorting.

There have been many famous and infamous examples of traders making their fortunes by shorting assets and markets.

Kyle Bass, for example, bet about $4 billion against US subprime mortgage-backed securities right before they sent the global markets into a crash.

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The Short Float Explained

A stock’s short float is the percentage of shares which investors are shorting relative to the total available — or floated — shares.

Another term for it is ‘short interest’, which says it all.

Learning about a stock’s short float means you’re learning how many investors are betting that the share price is going to fall.

According to ragingbull.com, the short float for a given stock rarely exceeds 50% — although it’s not impossible.

Generally speaking, you could say a stock had substantial short interest if the short float were above 40%.

A figure like that tells you that 40 in every hundred of a company’s unrestricted shares have been borrowed by short sellers.

Remember, shorting a stock involves borrowing from a broker, selling at market prices and agreeing to buy back and return at a specified time.

What does that mean for the everyday investor?

Primarily, you might look to the short float as an indicator of market sentiment.

While I personally prefer a value-based fundamental analysis approach, you could, for example, use the short float information to compare against a stock’s fundamentals to gain a clearer idea of where the price might be going.

How Do You Find Information On A Stock’s Short Float?

The exchange on which a stock trades should publish the numbers indicating short interest regularly.

The NYSE publishes short numbers twice a month, for instance.

Check with your local exchange to make sure you know where and when to access the data.

How Understanding A Stock’s Short Float Could Help

While the short float isn’t a complete indicator of coming price action or sentiment around a stock, it can help you understand a couple of things.

If you find that a stock has high short interest, this may mean that the company is struggling and that prices are indeed on their way lower.

If you are comfortable and competent with short selling, perhaps you’ll choose to use that as an opportunity to short.

Or, according to ragingbull.com, high short interest may be indicating that while a stock could be about to drop in value, investors are expecting the price to bounce back.

They may be trying to short the stock lower and then buy shares before it rebounds — trying to profit on the way down and the way up.

It’s never going to be obvious exactly what high short interest indicates about a given stock. There’s many possibilities.

That’s why, in my case at least, I’d be looking to pair my understanding of the short float with other forms of analysis.

For me, that would be fundamental analysis and company valuation.

For others, maybe that means technical analysis or research into news around the business and future events that could impact its profitability.

If 40% Is A High Short Float, What’s A Low One?

This trader points out that in 10 years of trading, they’ve seen a lot of short float data.

It’s possible that a short float can go to zero — that there are no borrowed shares at all and no one willing or able to short the stock.

That’s rare though.

Generally, you’d consider a stock to have a low short float if it were around 10%-20%.

When there’s little supply, as in a low float, it won’t take as much volume to produce a price movement.

For example, 10,000 shares changing hands in a stock that has a float of 1 million would, in theory, create a bigger price movement than if that stock’s float were 10 million.

In terms of the short float, this relationship between the amount of shares available and the volume matters, too.

• It’s important to understand that float matters relative to volume.

• You can think of the float as the supply of shares at any given time.

• You can think of volume as the demand.

Calculating The Short Interest Ratio

The short interest ratio is a means of understanding what a stock’s short float could tell you about upcoming price action.

You can work out the extent to which short sellers are targeting a stock by calculating its short interest ratio.

How do you do it?

It’s easy.

You just need to find the short float number — remember, that’s just the amount of available shares traders have borrowed for short positions.

Then, divide that number by the stock’s average daily volume.

Some investors will refer to this ratio as ‘days to cover’.

The short interest ratio will give you the approximate number of days it would take for the market to ‘cover’, or buy, all the short positions in the stock.

The bigger the ratio, the longer it could take for the market to buy the shares from the short sellers.

And the longer it would take the market to buy those shorted shares, the higher you’d judge the short interest in that stock.

The short interest ratio will rise and fall as trades and volume fluctuate.

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How Investors Can Use The Short Interest Ratio

Here’s a great example of the short interest ratio at play with Tesla.

Take a look at the charts:

The three charts show…

1. How many days it would take for the market to cover the Tesla short positions — in other words, the short interest ratio.
   
   
2. The number of shares borrowed for short selling (the short float).
   
   
3. The daily average trading volume for Tesla stock.

This example illustrates that the relationship between the short float, short interest ratio and volume don’t always move in sync with each other.

According to the article:

‘In July and August 2016, the short interest ratio rose despite the number of shares short falling.

‘That was because the daily average volume fell sharply during that time.

‘Additionally, the short interest was steadily declining in 2018 despite short interest being elevated because the average daily volume was steadily rising on the stock.’

You can see that — as with most things in investing — understanding the short interest in a stock is not an exact science.

It’s important to consider information like the short float, short interest ratio and volume in relation to one another.

Short Interest Ratio Limitations

One of the main limitations of the short interest ratio — and the short float — as an indicator, is that it’s only updated relatively infrequently.

Generally, the market reports the short float (and therefore the short interest ratio) every fortnight.

By the time that information reaches the market, the short positions in a stock could have grown or shrunk.

Volume, too, fluctuates far more frequently than every two weeks!

The short interest ratio — even if were updated on a daily basis — is really only a guide.

Current events and market news also impact trading volumes greatly.

Think of the stock in the example from Investopedia above, Tesla.

This is a stock that often produces dramatic price movement thanks to its high profile business operations and highly visible CEO.

If you were looking at the short interest ratio on the day Tesla announced its massive Bitcoin investment in early 2021, for instance, and that information was two weeks old, the numbers probably wouldn’t be accurate at that time.

Short Float Versus Short Interest Ratio

Now that you know what the short float and the short interest ratio are, be sure to understand the difference between the two.

Remember, the short float is the number of unrestricted shares investors have borrowed to short sell in the hope that they can buy them back at a lower price.

Investors will sometimes refer to the short float as short interest.

But short interest and the short interest ratio are two different things.

The short interest ratio is a formula you use to determine how many days it would take the market to buy — or cover — all the shorted shares.

Now You Know How To Determine & Interpret The Short Float

If you came into this blog post unsure about what short selling, short float and short interest meant, I hope you now have a much better idea.

Like other methods of analyzing a stock, trying to interpret short interest isn’t an exact science.

When you’re sizing up a potential investment and trying to determine whether you want to risk your capital on it — and bearing in mind this post is general information, not investment advice — you can never be 100% sure what a stock is going to do next.

But, what you can be sure of is how your investments and portfolio are performing to date given the decisions you’ve made.

While past performance is no guide to future returns, understanding the details of your portfolio performance is, I believe, a crucial part of forging a profitable wealth building journey.

That’s why my team and I developed the Navexa portfolio tracker — a platform that gives you in-depth true performance analytics on your stocks, ETFs, cash accounts, cryptocurrencies and even unlisted investments like property.

Dividends don’t always arrive in the form of cash. Some stocks allow investors to automatically reinvest their dividend payments into additional shares. Here, we take a look at some of the positives and negatives associated with reinvesting investment income instead of receiving dividend payouts as cash.

So, you’re collecting dividend income from your investments.

Great!

Investing in quality dividend-paying stocks can be a brilliant way to boost your returns — see how one of my income investments paid back nearly half my capital in just four years.

There’s more to dividend investing than just getting paid to hold shares, though.

Some stocks don’t simply pay you a cash dividend on a regular basis.

They give you the option to reinvest your dividend income into additional shares.

As you’ll see in our post explaining dividend reinvestment plans (DRPs), this option can have powerful effects on long-term returns.

On a long enough timeline, a DRP could be the difference between making a few hundred thousand dollars on an investments, and a couple of million.

But that doesn’t mean that choosing a DRP for your investment income is always going to be the default best option.

In this post, I’m going to go through three pros and three cons of reinvesting your dividends.

I should point out, though, that this is by no means an exhaustive list.

(Nor does it constitute financial advice.) 

DRP Pros: Compounding Through Increased Exposure & Saving On Brokerage Fees

• Compounding

I like what Einstein (allegedly) said about compound interest being the eighth wonder of the world.

The true wonder of compounding only becomes apparent with enough time.

As a long-sighted value investor, I try to let time work for me.

By that, I mean I look for quality, undervalued stocks and I buy them with a view to going ‘The Full Buffett’ and holding onto them for decades.

If you’re prepared to be patient and hold an investment for a long time, a DRP might work in your favour.

Why? Because over time, not only will your additional shares compound the size of your overall position, but you’ll receive more shares each time (since dividend amounts relate directly to your position size).

In some cases, with the right companies over a long enough time, you could double the size of your position simply by allowing reinvested dividends to accumulate.

• Increasing Your Exposure

Another advantage of using the DRP on an investment is that, over time (and again, the more time you allow, the more powerful the effect could be) is that accumulating more shares increases your exposure to the stock.

If you’ve selected a quality company to invest in, and the company’s stock increases in price over time, you will have more shares exposing your portfolio to that capital gain.

In simple terms, if you had 1,000 shares worth $10,000 in a company that rose 100%, you’d have 1,000 shares worth $20,000.

But if you’d reinvested your dividends and that had netted you, say, an extra 200 shares, you’d have 1,200 worth $24,000.

• Acquiring Extra Shares Without Paying For Them

One of the factors many investors neglect to consider when calculating their TRUE returns is brokerage fees and other transaction costs.

Generally, when you make a trade, you’ll pay your broker a fee to facilitate that trade.

This is another reason why I favour longer term, relatively inactive investing as opposed to buying and selling frequently, trying to chase trends or predict the market.

If I hold a single investment for 20 years, the fact that I paid, say, $100 brokerage becomes virtually irrelevant when I annualize my return.

And if you prefer not to let fees eat into your returns, you might like the DRP option, too.

Some stocks’ DRPs allow you to accumulate the additional shares for zero fees, since you’re not buying through a broker but rather have a direct agreement with the company itself.

So, those are three upsides to DRPs. In my view, investing this way only really delivers a meaningful advantage if you allow enough time for compounding, increased capital exposure, and the benefits of not paying brokerage on your additional shares to accumulate.

Now, let’s take a look at the downsides of DRPs.

DRP Downsides: Opportunity Cost, Less Control, And The Flipside of Increased Exposure

• You Don’t Control The Price Of Your Additional Shares

Acquiring additional shares through a DRP is great, in principle. Like I said, on a long enough timeline, and provided you’ve invested in a quality company that grows stronger and more profitable, it’s a sound idea to acquire more shares.

But like I also said, I’m a value investor.

I only buy shares in a stock I calculate is trading under its intrinsic value.

If you share that approach to buying stock, you may find that a DRP has an unintended downside; acquiring additional shares at prices above what you’d choose to pay were you analysing the stock with fresh eyes as a new investor.

Not only do you not get to choose the price you pay for each bundle of additional shares, you don’t get to choose the timing of the reinvestment, either.

So, in terms of control and in the spirit of not paying more than you want to, a DRP may be a downside.

• Opportunity Cost

The essence of the DRP is that you receive shares instead of cash.

As we know, this can have plenty of benefits, especially if you’re investing for the long term and intend to let the power of compounding work its magic over.

However, one potential downside of opting for a DRP over a cash dividend, is that you’ll miss out on opportunities to do things with that investment income other than automatically convert it into additional shares.

In other words, opting to reinvest your dividends could have a negative impact on your portfolio diversification.

Consider early 2021’s cryptocurrency bull market.

Say you’d been reinvesting your dividends in one of your stocks for five years, and you’d turned a $10,000 position into a $20,000 position (between capital gains and the DRP).

Not bad, a 100% gain.

But say you’d taken the cash dividend instead and invested it in Bitcoin, you could have exposed that income to far greater capital gains.

Of course, this is a simplistic example that benefits from hindsight (five years ago and even today, many still wouldn’t recommend cryptocurrency as a sound investment).

The takeaway here is, while a DRP can be a powerful tool in compounding your investment income and position size, it can also cost you the opportunity to invest your dividends in other assets and opportunities.

• The Flipside Of Increased Capital Exposure

This potential downside is a reflection of the potential positive we mentioned above — increasing your exposure.

Because, of course, if a DRP increases your exposure to a quality stock’s capital gains, it can equally expose your capital to greater losses.

This is something you should always take into account if you’re reinvesting your dividends back into a stock — and of course any time you invest — your capital is always at risk.

While the stock market does generally rise over the long term, that doesn’t mean every stock does.

Everything, in theory, can go to zero.

So if you were invested in a company that collapsed or went bankrupt, that increased exposure through your DRP could result in you losing more money than you might have if you had simply collected your dividends as cash.

Dividend Income: To Take The Cash, Or Reinvest?

Dividend reinvestment can be a valuable tool for the investor.

Of course, like any decision we’re faced with when trying to build wealth in the market, there are pros and cons.

Using a DRP to compound your income and capital can be a powerful way to grow your portfolio.

Compounding, increased capital exposure, and zero or few brokerage fees are in my view key benefits of utilizing a DRP.

On the other hand, increased exposure could bring increased risk, while DRPs may also inhibit you from investing in other opportunities or diversifying your portfolio.

The other key potential downside to DRPs is that you lose control over the timing and price of the additional shares your dividends will earn you.

In my opinion — and bear in mind I am not a professional investor or advisor — it’s important to view a DRP investment in both the wider context of your overall portfolio and financial goals, and — in my opinion — through the lens of long term investing.

I hope this post on the pros and cons of DRPs has been helpful for you.

I’ll leave you with one of my favourite investing quotes, from Warren Buffet’s business partner, Charlie Munger:

“The big money is not in the buying and selling. But in the waiting.”