What is it, exactly, that makes Insider Trading wrong? 1

When someone with special access uses non-public information to buy or sell stock, it’s called insider trading, and it’s against the law. But why? This was a simple question posed to me by a coworker earlier this week. The answer to the question is less obvious than I initially thought, but comes down to this: when insiders enter the market, they reduce the reward-to-risk ratio of investing, and cause dramatic harm to our economy’s ability to finance capital and innovation.

Let’s begin by defining the concept of insider trading, because there’s more to it than meets the eye. After all, we all trade on private information. From individual investors following their gut to large corporations hiring swarms of research analysts, an efficient market requires that individuals contribute their insight in order for prices to accurately reflect the value of underlying securities. Where we draw the line with insider trading is when people entrusted with private information specific to a company use it deal in its securities.

Let’s use a concrete example. If the CFO of Wal-Target – let’s call her Jane – sees that the price of WT stock is at $10.00, and she knows that tomorrows’ earnings announcement will blow market expectations out of the water, what harm is being done by her emptying her checking account to buy up as many shares of WT stocks as her savings allow? And in particular, how is this different from a case in which the CFO’s grandfather, Karl, whose knees hurt whenever the economy is about to plummet, uses that information to sell all his WT stock – some of which, presumably, will ends up at Jane’s brokerage account?

The difference, I propose, is risk, and insider trading’s adverse effect on the risk-reward trade-off. In the case of Jane, her risk is mitigated by the fact that she knows that the earnings beat expectations, and thus the likelihood of the stock going up is strictly better than 50:50. By comparison, her grandfather Karl has no such guarantee – by the efficient market hypothesis, in the absence of insider trading, he as likely to right as he is to be wrong about WT beating the market on any particular day. Thus, in pursuit of the same reward (the stock price increasing) Jane takes on less risk, and Karl takes on more risk.

Now I’ve stressed the risk and reward trade-off here because it of paramount importance. Let’s take a step back. By simple observation, we know that there are people out there who are more risk averse and less risk averse. Risk takers are willing to put their money to invest in things and take a chance that their investment will yield a massive reward. Risk averse people will prefer to take their paycheck and call it a day. Conversely, as the returns on a risky investment go up, people who were previously risk averse may suddenly jump into the market. Perhaps they wouldn’t buy a $1 lottery ticket with a chance to win $1,000 – but if the same ticket with the same odds of paying $30,000, they’ll do it.

Let’s put this all together. When people like Jane are buying stock from people like Karl, their presence in the market lowers the return to risk ratio for the rest of the market’s participants. In the absence of any insider trading, Karl’s likelihood of being right about WT stock falling was 50:50; now, with insiders like Jane entering on the buy side, the likelihood of being right falls, because the game is rigged. Whenever a stock is bought or sold, there are two parties; when insiders move billions of dollars, it increases the likelihood that you will be paired with someone who doesn’t just suspect, but knows they are beating the odds in this transaction – and you, consequently, are not.

It follows that in a market with insider trading, you are suddenly taking on more risk without any increase in reward. What will happen? It’s straightforward: fewer people will invest in the market. For example, individuals who accepted a 50% chance that their investing would pay off might leave if there is now only a 40% chance that their investment will pay off.

At this point, if you are really a skeptic, you might ask: what’s wrong that? Don’t we have enough investors? The answer is no, and it gets to the heart of how our economy works. Just like health insurance spreads around the burden of our healthcare, the presence of many investors diversifies risk and allows capitalist economies to make risky bets on technology and innovation because more people shoulder that risk. As the 2008 financial crisis showed, no institution or bank, regardless of its size, can carry the risk of a volatile market alone. Spreading that risk across all investors, big and small – through 401k’s and retail investors picking up instruments like MREIT’s – is widely beneficial approach if we want to keep people taking chances on financing new ideas. Moreover, sharing risk allows everyone to benefit from the fruits of capitalism. By making sure the reward-risk ratio is as advantageous as possible, we can ensure that we maximize the number of market participants who are benefitting from the profits of U.S. companies, rather than simply retreating to government bonds paying 1% interest rates.

Insider trading retards all these processes. It lowers the return for any given level risk, and if widespread, it will cause more risk-averse investors to exit the market; that in turn will make it harder for companies to borrow money, harder for startups to get capital, and harder to invest your retirement savings in your 401k. It will also begin a form of rent-seeking – a race to the bottom as employees abandon engineering and other productive jobs and swarm to positions where they can acquire private information that will allow them to be on the winning end of a corrupt stock market. A handful of individuals will get these jobs and win out – but at the cost of a less productive economy, fewer new companies, and a gradual but steady deterioration of the power of the U.S. stock market.

One comment on “What is it, exactly, that makes Insider Trading wrong?

  1. Reply Isaac Feb 28, 2014 1:11 am

    Thought provoking post. I want to add that it scams the people selling the stock to the person trading on insider information out of the upside.

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