After successfully prosecuting Raj Rajaratnam for insider trading, Southern District U.S. Attorney Preet Bharara issued a statement, saying that "Unlawful insider trading should be offensive to everyone who believes in, and relies on, the market."
WSJ reporter Jonathan Cheng breathlessly reported that:
In scoring their biggest insider-trading victory in a generation, regulators have a message for a nation of nervous individual investors: When it comes to information about stocks, the playing field is getting a little more level.
The little guy isn't so sure.
Piffle. Insider trading does not harm investors -- little or otherwise. As I explain in my book Securities Law: Insider Trading
Insider trading is said to harm investors in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss.
The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to the shareholder’s loss is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not.
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. On an impersonal trading market, neither party knows the identity of the person with whom he is trading. Thus, the seller has made an independent decision to sell without knowing that the insider is buying; if the insider were not buying, the seller would still sell. It is thus the nondisclosure that causes the harm, rather than the mere fact of trading.
The information asymmetry between insiders and public investors arises out of the mandatory disclosure rules allowing firms to keep some information confidential even if it is material to investor decision-making. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.
Arguably, for example, the TGS shareholders who sold from November through April were not made any worse off by the insider trading that occurred during that period. Most, if not all, of these people sold for a series of random reasons unrelated to the trading activities of insiders. The only seller we should worry about is the one that consciously thought, “I’m going to sell because this worthless company never finds any ore.” Even if such an investor existed, however, we have no feasible way of identifying him. Ex post, of course, all the sellers will pretend this was why they sold. If we believe Manne’s argument that insider trading is an efficient means of transmitting information to the market, moreover, selling TGS shareholders actually were better off by virtue of the insider trading. They sold at a price higher than their shares would have commanded but for the insider trading activity that led to higher prices. In short, insider trading has no “victims.” What to do about the “offenders” is a distinct question analytically.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. It is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade, however. While derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the correct price; i.e., the price that would prevail if the information were disclosed. In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
An argument closely related to the investor injury issue is the claim that insider trading undermines investor confidence in the securities market. In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets.
There is no denying that many investors are angered by insider trading. A Business Week poll, for example, found that 52% of respondents wanted insider trading to remain unlawful. In order to determine whether investor anger over insider trading undermines their confidence in the markets, however, one must first identify the source of that anger. A Harris poll found that 55% of the respondents said they would inside trade if given the opportunity. Of those who said they would not trade, 34% said they would not do so only because they would be afraid the tip was incorrect. Only 35% said they would refrain from trading because insider trading is wrong. Here lies one of the paradoxes of insider trading. Most people want insider trading to remain illegal, but most people (apparently including at least some of the former) are willing to participate if given the chance to do so on the basis of accurate information. This paradox is central to evaluating arguments based on confidence in the market. Investors that are willing to inside trade if given the opportunity obviously have no confidence in the integrity of the market in the first instance. Any anger they feel over insider trading therefore has nothing to do with a loss of confidence in the integrity of the market, but instead arises principally from envy of the insider’s greater access to information.
The loss of confidence argument is further undercut by the stock market’s performance since the insider trading scandals of the mid-1980s. The enormous publicity given those scandals put all investors on notice that insider trading is a common securities violation. At the same time, however, the years since the scandals have been one of the stock market’s most robust periods. One can but conclude that insider trading does not seriously threaten the confidence of investors in the securities markets.
In A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing
Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (which a lot of people did back during the dot-com stock bubble), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it famously did for dot-com stocks).
The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would not be profitable.
In the last section of A Random Walk Down Wall Street
