Investing Basics For Beginners Installment #1: What is Stock? And Should You Buy Some?

Introduction to this Series

This is the first of a series of articles that will teach you about investing. We start off pretty simply by answering the question, “what is stock?” Each installment builds on those that came before it. I suggest you read them in order but be sure to follow the hyperlinks I’ve embedded throughout, as they will take you to other resources you should review. By the time you’re done reading this series, you should be knowledgeable enough to start investing in the stock market, or at least to better understand your financial advisor when she or he speaks with you. If you own stocks but don’t understand the information this series conveys (or you choose to ignore it), then you’re not an investor but, rather, you are a speculator, gambler, trust fund kid who can afford to lose a lot of money, or something else- – but not an investor.

What is Stock?

A share of “stock” represents partial ownership in a business. If you are the sole owner of a business that is organized as a corporation, then you own 100% of the stock of that business. If you are the sole owner of a business that is organized as a limited liability company (“LLC”), then you own 100% of the membership interests of that business. An umbrella term that includes both stock in a corporation and a membership interest in an LLC is “equity.”

Equity (Stock or Membership Interest) in a Private Company

The vast majority of businesses in the United States are privately owned. And most privately owned businesses are operated by their owner(s). That is, they are not passive investments. I’m talking about the bagel shop you eat at most mornings that Bubba runs; the dry cleaners owned by that lovely couple who go to your church; and the law firm owned by Carol, the lawyer who helped you with your divorce, and her senior partner, Lucile.

Chances are that none of those people are going to sell you any of the equity in their company. It is more likely that one of them might be interested in selling you 100% of the equity of their business (although if you are interested in buying a business, then you may prefer to buy the assets of the business rather than the equity. Either way, buying an entire company (whether by buying its equity or its assets) is an entirely different topic. If you want to learn more about that, then check out the Financial Poise series, Business Transition and Exit Planning.

But let’s say you end up buying only some of the equity of one of their companies, as sometimes happens. In that case, you may be taking an active role in the management of the business. If not, then you are making a passive investment in the equity of a private company. And if you are doing that, then you are buying an unregistered security.

This type of investment—making a passive investment in the unregistered securities of a company—is not the subject of this series. It’s important, however, and if you want to understand more about it, then you can start by reading Alternative Assets and the “Average” Accredited Investor Installment #3 and What is the JOBS Act: 2019 Primer for the Private Company C-Suite Executive,

To be clear, however, these are not the type of securities you should consider buying unless you already understand the stock market and have a substantial investment portfolio consisting of publicly traded stocks or mutual funds (i.e., registered securities).

Registered Securities (Stock) of Public Companies

With this context, let’s get to the main event: the title of this article asks what is stock, and should you buy some?

The answer to the second question is maybe, but only gradually. I say maybe because many investors are better off owning stock mutual funds instead of individual stocks. Also, if you knew nothing about the stock market when you started to read this article, then you should read at least the first few installments before you buy any stock.

The answer to the first question is that when people talk about investing in the “stock market,” they mean investing in a stock that is registered with the SEC A company whose stock is traded on a national securities exchange, like the New York Stock Exchange or the Nasdaq, is a public company (but not all public companies trade on a national securities exchange— more on that below). One fundamental benefit of investing in the stock of a public company is that you can buy or sell it almost instantly. It is thus a fairly liquid asset. Another is that a public company is subject to strict requirements to disclose a lot of information about itself and that the people who run them face severe consequences if disclosure obligations are violated.

So, when I talk about investing in “stock” (or the “stock market”), this is what I mean. And, again, yeah, you should be invested in the stock market.

Not All Public Companies Trade on a National Securities Exchange

As I note above, not all public companies trade on a national securities exchange. Some examples of the about 12,000 public companies that trade not on a national securities exchange but, rather, trade over-the-counter (“OTC”) are:

• Adidas
• Bayer
• Daimler
• Mitsubishi
• Nestle
• Volkswagen

You may realize that these examples are all based outside the U.S. If you invest in one through the OTC then you do so by buying American Depositary Receipts (“ADRs”).

But ADRs account for a very small percentage of OTC. Many are very small companies (penny stocks, for example, trade OTC) that cannot meet the requirements to be listed on a national securities exchange. A company whose shares trade on a national securities exchange, by the way, is commonly referred to as “listed.”

One key difference between the stock of a company that trades OTC and one that trades on a national securities exchange is the amount of publicly available information about the company. Information about OTC companies can be difficult to find, making them more vulnerable to investment fraud schemes and making it less likely that quoted prices in the market will be based on full and complete information about the company.

Another key difference is that OTC markets are not conducted as auctions. Rather, they work more like a flea market, which makes OTC stocks generally less liquid and more volatile. OTC markets, by the way, are not used just for stock trading. Rather, they are used to trade a wide variety of assets.

OTC Markets Group, a public company that itself trades OTC, has created three tiers based on the quality and quantity of publicly available information about a company. These tiers are designed to give investors insights into the amount of information that companies make available. Securities can move from one tier into another based on the frequency of financial disclosures. The tiers give no indication of the investment merits of the company and should not be construed as a recommendation. The tiers are:

• OTCQX- This is considered the highest tier of OTC Markets’ securities based on the amount of available information. In order to be eligible for the OTCQX tier, the company at issue must be current on all regulatory disclosures, maintain audited financials, and cannot be a penny stock, a shell corporation, or be in bankruptcy.
• OTCQB- This tier is designed for early-stage or growth companies. Companies must have a minimum bid price of $0.01. These companies must be current in their regulatory reporting and have audited annual financials in accordance with U.S. Generally Accepted Accounting Principles (GAAP). As with OTCQX, these companies cannot be in bankruptcy. I recommend this resource for more information about OTCQX stocks.
• Pink Market (“Pink Sheets“)- Also known as the “Open Market,” this tier has no minimum financial standards. It includes a wide variety of companies, including foreign companies, penny stocks, shell companies, and other firms that choose not to disclose financial information. Within the Pink Market, firms are classified as showing Current Information, Limited Information, or No Information.
• Grey Market- All other securities that are traded over-the-counter are on the Grey Market. Grey Market securities are not quoted by broker-dealers due to a lack of investor interest, lack of financial information, or lack of regulatory compliance.

Taking a step back, the term “public company” can be defined in various ways. As the SEC states on its website, “[t]here are two commonly understood ways in which a company is considered public: first, the company’s securities trade on public markets; and second, the company discloses certain business and financial information regularly to the public.” The SEC, however, considers a company to be “public” if it has public reporting obligations. Blah blah blah.

Look, the bottom line is this: the part of your investment portfolio that you have allocated to the stock of publicly traded equity securities should be limited to those traded on New York Stock Exchange, the Nasdaq, and- if you’re feeling particularly sassy- the OTCQX.

Ok. Are you ready? We have a lot of unpacking to do. So let’s get started.

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Jonathan Friedland is not an investment advisor. He holds no relevant licenses, nor does he have formal education in the area of investing. He is, however, an avid and reasonably successful investor in both private and public companies who has few other hobbies, a day job that has forced him to learn some of the same skillsets that some financial advisors have, and who is passionate about financial literacy. This article, like all articles published by Financial Poise, is subject to these legal disclaimers. This series draws in part on information that is publicly available at investor.gov and other websites owned by the U.S. federal government.

Series Overview:

1. Installment #1: What is Stock? And Should You Buy Some?
2. Installment #2: Investing is Risky But Not Investing is Riskier
3. Installment #3: Never Put All Your Eggs in One Basket
4. Installment #4: Why Invest in Public Companies?
5. Installment #5: Understanding the Players in the Stock Market “Game”
6. Investing Basics For Beginners Installment #6: “Regression Toward The Mean”– A Hoity Toity Term Every Investor Should Understand

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Basic Investment Principles 101 – From Asset Allocation to Zero Coupon Bonds
• Alpha, Beta & Other Key Concepts]

©2021. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.