Go easy on insiders
Flow of free information vital, writes Jake van der Kamp
I cannot get myself worked up about dealing on inside information. I don't approve of it but it does not seriously offend me and, in fact, I think it does no great harm to financial markets.
I shall go further than this. It is my opinion that most of the indignation voiced about insider dealing is the work of securities regulators, who would find employment lacking if they could not generate it for themselves by imposing standards of morality appropriate to convents.
And while such strict rectitude is ostensibly enforced in order to protect small investors, I think it actually has the effect, in practice, of putting them at a disadvantage by raising their transaction costs and depriving them of worthwhile information.
Most of all, I think it just doesn't work, except, of course, in its purpose of creating employment for regulators.
Take, for example, the question of price discovery. It is a simple fact that no individual investor can know everything there is to know about the share price of an individual stock, let alone how much significance to ascribe to each item of information. And what is not possible for one stock is certainly not possible for any individual to know about every stock on the entire market or the entire range of tradable securities.
But the overall market, the combined knowledge of every investor who takes an interest in a stock, is a fairly good determinant of what the share price ought to be. The only difficulty is that this opinion is not voiced. It is only expressed in the share price itself.
On that basis it would not seem to do much good for people who want to make money from the stock market. By the time the share price tells you where it is going, it is already there. The only pundits who see significance here are technical analysts, people who think patterns of share price moves and trading volume have predictive value.
Technical analysis represents about 60 per cent of the talk among retail clients in brokers' dealing rooms, whether online or physical (the other 40 per cent is putative inside information), and there is indeed reason to believe that share prices often move in recognisable ways ahead of major reversals of direction. But technical analysis is mostly regarded as the voodoo side of investment analysis.
Leaving technical analysis aside however, it can be quite a good thing for retail investors that the market has already taken into account all the factors affecting a share price at that share price's present level. It means that they do not really have to do any hard investigative work about which stocks to buy. Their win/lose odds are 50/50 on all stocks at their present share prices.
This feature of rapid price discovery means that the stock market is, in a way, a straight, fair odds gamble for everyone. No one stock can be considered better at its present level than any other stock. If its prospects are good its share price will be relatively higher on standard investment benchmarks to reflect this fact, and vice-versa if its prospects are poor.
But rapid price discovery crucially depends on a free flow of information to the share price. Choke the process by which information can move the share price and it will not work as well any longer.
Thus take the case of the insider who learns one morning that his company has incurred a major unexpected loss and who immediately dumps his shares. The share price immediately responds to the selling pressure and by noon has fallen significantly.
Along comes an innocent retail investor the same afternoon with a buy order for the stock. He now gets it at a lower price than he would have been quoted had the inside dealing that morning not driven the share price down. Rapid price discovery has done him a good turn.
Of course, you can also say that another innocent retail investor who was a holder of the stock the day before never got a chance to sell at the higher price. The insider robbed him of this opportunity.
It's true and I don't deny it, but the sum total of this story is nonetheless that one innocent retail investor gained and another lost. The win/lose ratio for innocence in this incident was 50/50. Inside dealing did no net damage to innocence overall.
There are two other observations I would make here. The first is to mistrust declarations of innocence in the stock market. When things go wrong, all retail investors declare they are 70-year-old grannies who just bought stocks for the first time. If they spoke the truth they would take no umbrage when then told to go home because stock markets and shark ponds are no places for grannies. They always take umbrage.
The second observation is that these people would be less at the mercy of insider dealers if they were investors rather than speculators - if they held their stocks through a few ups and downs rather than dealing rapidly in and out of them. If you treat the market as a casino it will treat you in like fashion.
But let's say I'm wrong about the balancing effects of price discovery. Let's say that the key to successful investing is to do a great deal of homework on all the stocks in the market and that close study will inevitably lead to success in picking the best ones. Let's say that any retail investor who is paid nothing for doing this work can still be as well rewarded by share price appreciation alone as the trained professional who is paid a regular big salary in addition to any profitable trades he makes.
If this is true then the retail investor must have full access to information and the objective of regulators must be to ensure that this information flows freely and voluminously.
In practice, however, the speed and volume of information flows on the stock market are in inverse proportion to the severity of regulatory strictures imposed.
What regulators mean by full information is notices to the stock exchange, hundreds of them every day, all written by lawyers in lawyer language to protect their employers from regulators in every conceivable eventuality, a spring torrent of verbiage that no one has the time to read, let alone understand, and which is generally meaningless anyway or old news.
But as every real investment practitioner knows, real information, the good stuff that has meaning, is the rumour mill. What it tells you may not be the exact truth every time but when rumours pass through the market there is invariably some truth behind them, and you do well to make your investment decisions accordingly.
The churnings of the rumour mill, however, cannot be passed along to retail investors when regulators are watching. Rumours could be inside information or they could be the means of market manipulation. Best not risk a jail sentence by letting retail investors swim in this flow of information.
What retail investors should consume is baby food - sanitised research reports by investment analysts who are analysts because they don't really understand the market and are not much good on the dealing desk (the good ones invariably graduate to the dealing desk). Retail investors need to be told that the share price could go up, could go down, could go round and round and, on balance, the investment firm believes that you should do nothing in the absence of fresh factors. Here are eight pages to prove it, three of them filled with disclaimers in small type.
Thus, one significant result of enacting criminal laws against insider dealing in order to create a level playing field for all investors is to deprive retail investors of worthwhile information and so widen the information gap between them and the professionals. A playing field that can never be truly levelled has been tilted even further.
This is, of course, only true if you believe hard work at studying stock information will give you an edge in dealing rather than just a headache. In my view it is occasionally true, but not often enough to be worth the headache and the waste of the waking hours.
I don't have a great deal of faith in the hard study theory. In my view, stocks are generally a better idea for your investment cash than bank deposits (where you truly get ripped off), and the information flow between people who really move markets is still efficient enough to give retail investors pretty good price discovery and close to 50/50 odds on anything they buy.
I shall say it again. I just cannot get worked up about the evils of insider dealing. It has never seriously hurt retail investors who did not themselves jump in and out of the market on what they thought was inside information. Trying to stamp it out has also made things worse for them in many ways.
Caveat emptor - let the buyer beware - is a wonderful principle of law. Let's return to it and tell the regulators to find themselves an honest living rather than burden us with obstructions that have achieved little more than creating excessive salaries for regulators.