Tom's Life Bits

Q: I inherited a bit of money early this year and opened my first investment account with an adviser at a brokerage firm. Previously, I had only invested through my retirement account at work.

My adviser is about my age (mid-50s), and when I first met him and asked him how long he'd been in the investment business, he said less than 10 years. I've found out that actually means 13 months. He's a really nice guy, but now that I know he doesn't have a lot of experience, I am wondering if his most recent advice makes sense.

When we first met, I told him that I could handle some risk with the money I inherited since I never expected it anyway and that I wanted as much income as possible. He suggested we buy preferred stock that was at a low price. Now he is suggesting selling the preferred stock as a way to manage fixed assets in a rising interest rate environment.

He has tried to explain how my dividend yield has fallen as the stock price has risen. He says it is now down to 6percent based on the current stock price and if the dividend yield continues to fall and other investments such as CDs and bonds begin offering higher interest rates my stocks will be less attractive to other investors and therefore the price will decline. I agree that interest rates will rise in the near future, and I see his logic. I don't really know how preferred stocks work, but I thought if the purchase price of the stock provided me with a dividend yield of 12 percent that would still be my yield even though the stock price is now higher. He says that's not right, and I now need to think of it as a 6percent yield.

What a way to begin working with a “professional” investment adviser. I don't care how nice a guy he appears to be, you need to find a new adviser.

He sounds like he knows just enough to be dangerous, not to mention intentionally misleading you about his experience. If you bought stock early this year, you have probably experienced a nice increase in stock price in addition to the dividend payment. I'll provide a simple example that you are correct about your yield remaining at 12percent; but first, an explanation of preferred stock.

Preferred stock is an equity security representing shares of ownership in the corporation that issues the stock. A holder of preferred stock has preference in claims to dividends and assets ahead of the holder of common stock; preferred stockholders get paid first. They are paid before the common stockholder, but it is still an equity security, so you have no claim until every creditor is satisfied.

Preferred stock is bought primarily for income because of its fixed dividend payments.

Preferred stockholders receive dividends at a fixed rate based on the issue price or par value. The dividend is usually stated as a percentage of the par value. If your preferred stock has a $100 par value and the stated dividend rate is 6 percent, you will receive $6 per year for each share of preferred stock you own. If you buy a preferred stock for less than par value, your yield will be higher than the stated yield. Conversely, if you pay more than par value, your yield will be lower.

For example, if a preferred stock has a par value of $100 and a stated dividend rate is 6 percent, you will receive $6. If you are able to buy the same stock when it is $50 share, you still receive a $6 dividend for each share, which is a 12 percent yield. Your yield is determined using your purchase price, not the current share value.

If you bought a preferred stock at such a low price that it is yielding 12 percent and has now risen in price so that current investors are receiving a 6 percent yield, I don't see any reason to sell unless you decide that the underlying corporation is weak. If the corporation experiences financial difficulties that prevent it from paying dividends, your yield will go to zero and the stock price would decline.

If you sell now, you will pay ordinary income tax on the gain since you have held the stock for less than 12 months. If for some reason you choose to continue working with this adviser, ask him why he is suggesting you sell before qualifying for long-term capital gains treatment and where he plans to invest the proceeds to receive a comparable yield.
Holly Nicholson is a certified financial planner in Raleigh. Reach her at www.askholly.com www.askholly.com or P.O. Box 99466, Raleigh, NC 27624. She cannot answer every question.