NEW YORK (CNN/Money) - How would you classify preferred stock for asset allocation purposes — stocks, bonds or even cash?

— Mort Weissman

Preferred stocks are tricky little devils to categorize and analyze because they're hybrid securities, which is to say that in certain respects they're more like bonds and in others they're more like stocks.

Like bonds, they typically have a face value, or par value (typically $25 per share as opposed to the usual $1,000 face value of bonds). Their market price can and does vary from par, however, either because of changes in interest rates (like bonds, preferreds rise in value when interest rates fall and drop when rates rise) or in the credit quality rating of the issuer. (Like bonds, preferreds carry ratings from Standard & Poor's and Moody's.)

Preferreds are fixed-income securities, like bonds. That is, they pay a fixed dividend to shareholders. In most cases, that dividend is "cumulative," which means if the company misses a payment, dividends still accrue and missed payments must be made before dividends can be paid on the company's common stock.

At the same time, preferreds are like stocks in several respects. They can appreciate in value like stocks, although typically they don't have anywhere near the appreciation potential of common shares. And while preferred shareholders have a higher claim on a company's assets than common stock holders, they still stand well behind a company's bond holders.

Overall, even though preferreds are typically less volatile than regular stocks, they are still riskier than bonds, which is why their dividend yields often exceed the yields paid by investment-grade corporate bonds. (You can check out recent yields on preferred issues and learn more about how they work by going to sites such as Preferred Stock Online and QuantumOnline.

As for where preferreds belong as part of one's asset allocation strategy, what's most important issue isn't the label one attaches to a preferred, but how the security acts — that is, how its price fluctuates due to changes in interest rates and the outlook for the issuing company and how those fluctuations relate to the ups and downs of the other securities you own.

To get a handle on that first issue — a preferred stock's volatility — I recommend you go to a site such as Riskgrades, which provides volatility ratings on virtually all types of securities — stocks, bonds, funds, options and preferreds.

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Essentially, the rating compares each security's volatility to that of a world basket of securities, whose volatility, or Riskgrade, rating is set at 100 for a benchmark. The Riskgrade for the Standard & Poor's 500 is 54, which means the S&P 500 is roughly half as volatile as the global equity markets overall.

By contrast, the Lehman Bros. Aggregate bond index, which represents the U.S. bond market, has a Riskgrade of 22. The Riskgrade for speculative securities can run as high as 1,000, while cash has a Riskgrade of 0. (Riskgrades for individual securities can and do change depending on market conditions, although the benchmark for the basket of global securities remains 100.)

If you run your cursor over the "Get a Risk Grade" link that appears on every page of the Riskgrades site, a little screen will pop up where you can insert the ticker symbol of the security for which you want a rating. What you'll find in the case of preferreds — as with other securities — is that the rating can vary significantly depending on the quality of the company and the characteristics of the specific issue.

I recently plugged in ticker symbols for preferred issues from Alcoa, DuPont, Ford and Motorola, for example, and got Riskgrades of 109, 83, 39 and 34 respectively. Given that range, you can see why you've got to go beyond merely putting a stock or bond label on a preferred to see how it fits into your asset allocation.

In fact, you've even got to go beyond the Riskgrade for individual securities and get a Riskgrade for your entire portfolio (which you can do by creating a portfolio and entering ticker symbols for all your investments).

Why is this portfolio approach so important? The reason is that even if individual securities you own are highly flighty, the volatility of your portfolio overall may be much much lower as long as the issues don't all move in unison. In short, what really matters isn't the volatility of individual securities but the way your securities zig and zag in relation to one another.

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For example, the average Riskgrade for the four preferreds I mentioned earlier was 66. Yet the Riskgrade for a portfolio consisting of equal dollar amounts of those four issues was just 34. In other words, the volatility of the whole was only a bit more than half the volatility of the parts because the issues don't move in lockstep with each other.

So if you want a realistic look at how well the asset allocation mix in your portfolio is reducing risk, I suggest you high tail it over to the Riskgrades site and take a look not just at your preferreds but your holdings overall. Because when it comes to evaluating risk, the portfolio's the thing.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.