SAFT ON WEALTH: Insider trading – all the cool kids are doing it

April 11, 2013

April 11 (Reuters) – There are a bunch of kids out there
trading on inside information, and you, me and the rest of the
economy are paying the price.

A study of trading patterns in Finland shows a highly
suspicious pattern of activity in accounts held on behalf of
juveniles.

In reality, it is probably not the kids themselves who are
playing at being junior insider traders, but instead it is their
guardians who are likely using juvenile accounts as a safer way
to profit from non-public knowledge.

What’s worse, the data also demonstrates how the market
detects which companies’ stocks are most plagued by “informed
investing” and then imposes a penalty which effectively reduces
both investor returns and overall economic growth.

KID TRADERS

Using data on a half a million accounts from Finland from
1995 to 2010, the study came to a surprising conclusion:
accounts set up to benefit kids 10 years and under did really
well at stock picking, and did especially well just before
mergers, earnings releases and events that generate big stock
moves.

The analysis was possible since Finland makes available
unusually detailed information about the identities of
investors.

“When guardians trade through under-aged accounts, there is
a relatively high probability that they are trading on private
information,” the authors, Henk Berkman, at University of
Auckland, Paul Koch at the University of Kansas and Joakim
Westerholm at the University of Sydney, conclude in a paper
slated to be published in the Journal of Finance.

The gap between the junior set and typical accounts held by
adults was striking: in the day following trades made by kids,
their accounts outperformed the adult accounts by 9 basis
points.

Ahead of major earnings announcements, the kids chose
correctly whether to buy or sell 57 percent of the time and beat
their elders by 1.1 percent in the following day.

It gets even better – at least for junior. On trades made
the day ahead of a merger announcement, juvenile portfolios
outperformed by 12 percent the following day, and made the right
decision to buy or sell an uncanny 72 percent of the time.

The rest of the market, by the way, chose correctly whether
to buy or sell only 50 percent of the time.

This is probably not all due to inside knowledge, according
to the study. The guardians tended to be richer and may simply
have been more successful at investing, the authors argue, due
perhaps to higher intelligence or an advantage in obtaining
legal, but valuable information.

Even so, the fact that the juvenile accounts outperformed
ahead of mergers while the guardians’ accounts did not implies
that the adults were smart enough to know better than to trade
on inside knowledge in an easily traceable way.

HIGH COST OF CHEATING

When the authors looked at the stocks with the highest
proportion of trades by juvenile accounts, they found something
else to ponder: the Finnish stock market as a whole liked them
less than the rest of the market.

In other words, those stocks were punished by investors, who
demanded a higher return to compensate for their risks.

“If an uninformed investor perceives a greater likelihood of
trading against informed investors, that uninformed investor is
likely to demand a higher required return to buy such a stock,”
Paul Koch said in an email.

“Put another way, the uninformed investor is likely to be
willing to only buy this stock if the price is lower (and thus
the expected return required to invest in this stock is
higher).”

What this all boils down to is that anyone who owns a stock
thought likely to be subject to insider trading is hurt. So is
the company, whose cost of capital rises the lower the value the
market places on its shares.

While some argue that controls on insider trading are
wrong-headed, in that they tend to slow down the spread of
information, I’d counter that this study points to the real and
important costs.

People don’t like being cheated and they don’t like doing
business with cheats. To protect themselves, investors will
often impose penalties with very high costs all round. Funding
the Securities and Exchange Commission is one such cost, as was
Martha Stewart’s room and board while she was in prison.

To give a broad example, if Alexander Graham Bell had been a
known scoundrel, liable to cheat all his business partners, he
would have found it harder to raise money to develop the
telephone, thus slowing the adaption of an otherwise useful
technology.

A society with more insider trading will, all else being
equal, allocate capital less well, and grow more slowly.

If this is happening in Finland, which is ranked as being
the least corrupt nation on earth, it is definitely happening
elsewhere.

Time for the SEC to get cracking.

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