04 June 2012

It's three days before Microsoft is set to report quarterly earnings, and a hedge fund manager is hard at work. Not hard at work analyzing the company's supply chain to predict what their quarterly earnings would be, but hard at work eating a nice meal with his college friend, who happens to be the Microsoft VP of Marketing. At some point during the meal, the VP of marketing will tell the hedge fund manager what the quarterly number is going to be.

The hedge fund manager takes that information, and uses it to trade the stock, making a million dollars in just a couple of days. In return for the tips, the hedge fund manager buys his friend a new car for his birthday.

Insider trading is when a person trades on information that is both material and non-public. The material aspect of this information means the information needs to be important enought to effect the stock price. If you get a tip that company A is planning on buying company B, that would be material information. However, if you just saw the CEO's of company A and B eating together in a restaurant, that would not be material, because they could be eating together for any number of reasons.

In our case, what the hedge fund manager and his microsoft vp friend did is clearly insider trading, because the information being passed is material and non public.

If you listen to the financial news, and look at what the SEC is up to, you will find that people are obsessed over insider trading.

I'm here to say that insider trading doesn't matter, and that the time and energy spent obsessing about insider trading can be better spent somewhere else.

First, let's get on the same page about how insider trading affects investors. Simply put, it doesn't.

I'm making a deliniation between investors and speculators here. An investor is a person who buys the stock of a company because they believe in the company's long term success, and intends on holding the stock for a long period of time. A speculator is a person who intends to profit based on the short term fluctuations of a company's stock price.

Insider trading is only effective for short term trading. The reason is that, nobody, no matter how insider they are, is able to tell the long term future. In the long run, insider information either becomes public information, or no longer relevant. Therefore, if one were to attempt to illegally profit from insider information, the only way to do it is to make a big, leveraged, short-term bet.

On the other side of that big, leveraged, short-term bet is not a nice old grandma with her IRA money, it's another short-term speculator. The legal speculator thinks that he has an edge over the insider trader, and expects that this highly leveraged bet will result in a huge loss for the insider trader, aka the sucker who takes the other side of the trade. The difference is that the information from one party was legally obtained, and from the other party was illegally obtained. However, all parties in this transaction are sophisticated financial professionals, not common investors worrying about retirement.

Even though insider trading only affects short-term speculators, theoretically, we might worry that there wouldn't be enough speculators who would want to participate in the market because of all the insider trading. However, in the actual market as it exists today, the problem of insider trading is so miniscule on a percentage basis, that it doesn't pose a structural risk. The argument would be similar to worrying about society giving up air transport because planes sometimes crash.

So, even if it's true that insider trading doesn't affect normal investors, and doesn't pose a big risk to speculation, what's wrong with making a big deal out of this? It's still illegal and immoral, and those who do it should be punished, right?

Obviously they should be punished, but that doesn't mean we need to make as big a deal about insider trading, both from the press and from a regulatory perspective.

When the press makes such a big deal out of insider trading, it has the side effect that common people lose confidence in the capital markets. They believe that all these insider traders are stealing the money from their 401k's. This is simply not the case. The main purpose for writing this post is to communicate this point. Insider trading does not matter for normal people investing for retirement. We should be focusing on more important things.