Here are the Victims of Insider Trading, Hope I Didn’t Keep You Waiting Too Long

The way 2018 is going, it should not shock you too much that we’ve gotten to the “a little insider trading never hurt anyone” phase of the news cycle.

To be fair, the article isn’t as bad as the headline, but it’s still mistaken on a crucial mathematical point. Let’s discuss.

The arguments against allowing “insider trading” (i.e. buying and selling stocks based on information you have as a company insider but that the general public is not privy to) run across a pretty wide spectrum, from “it rips people off” on one end to “it erodes trust in markets” on the other. So let’s start with the ripping people off thing- in a broad sense, the stock market is not a zero-sum game since, when stocks increase in value, the pie of wealth to go around gets larger, so in this context there doesn’t have to be a loser for every winner. In a more narrow transactional sense, however, one party’s gain is in fact another party’s loss (or at least forgone gain). Let’s work through a simple example to see why this matters when it comes to insider trading.

Say there’s a stock that is currently trading at $10, but there is non-public information that suggests that the stock is worth $15. Once that information becomes public, the stock will trade at $15, so there is $5 of profit to be had in the course of the stock’s journey from $10 to $15. How this $5 gets split among different investors (savers, to use more precise economic language) depends on how the stock gets bought and sold during the price adjustment process. One simple case is where no insider trading occurs and the stock is only bought and sold once- in this world, some guy buys the stock at $10, sells at $15, and makes $5 profit. Note, however, that whoever sold the stock to this guy at $10 missed out on $5 of profit that he could have had if he had waited to sell- this is what is meant by one person’s gain being another person’s loss. In this scenario, what most likely happened is that one guy (the buyer) got lucky whereas the other guy did not. I could have given you a more complicated scenario that involves the stock changing hands more times, but it still has to be true that both the total profit and the total forgone profit add up to $5.

The insider trading scenario looks pretty similar, except that rather than getting lucky, the insider buyer has a systematic advantage that enables him to capture all $5 of profit, leaving none for, say, the teachers’ union pension fund. (Yes, I’m trying to make a point with this example- the stock market isn’t just douchebags gambling with one another., despite what CNBC might lead you to believe.) Again, the pension fund didn’t literally hand $5 over to someone else, but it missed out on $5 that it would have had if it had not sold the stock.

The argument that insider trading is victimless hinges on the notion that the guy (or organization) who sold the stock to the insider at $10 would have just sold the stock to somebody else for $10 if the insider hadn’t been in the market. This is probably true, but it just means that the first guy transferred $5 of profit to the second guy in a level playing field type scenario. (In other words, the second guy is now the one who got lucky and claimed the $5 profit.) Let’s say there are 100 shares of this stock in the market- this means that there’s a total of $500 in profits to be had from the price movement. Regardless of how I choose to describe it, it mathematically has to be the case that the insider took $5 in profit out of the system and left $495 for everyone else- in other words, I don’t have to specify who lost out in order to conclude that non-insiders are worse off due to insider trading.

Does this mean that ordinary investors can’t earn positive returns if insider trading is prevalent in a market? Not necessarily. Not all price movements are the result of information that could be of an “insider” nature- for example, if bad weather in Florida causes business problems for, say, Tropicana, it’s not like certain fancy people could have been told about the bad weather ahead of time. That said, I’m not convinced that “don’t worry your non-insider returns will just be lower but not totally zero” is terribly comforting to most people.

In addition, a critical mass of insiders in the market could make non-insiders reluctant to buy and sell (or, equivalently, hand their savings over to organizations that buy and sell). Think about it- wouldn’t you hesitate to do business with someone if you had to constantly wonder “what does this guy know that I don’t?” This isn’t all together different from the “lemons” problem that makes buying and selling, say, used cars difficult. (In finance courses, this information asymmetry is described by labeling the insiders as wolves and the non-insiders are sheep- would you want to do business as a sheep if you thought that everyone around you was a wolf?)

Hopefully I’ve made the logic of how insider trading is not a victimless crime a bit more clear…I’m not going to get into the morality of the activity (in general, the Venn diagram of illegal versus immoral is not a circle), but I will acknowledge that the original article lined above was unambiguously right about one thing- insider trading would in fact cause stock prices to adjust to their “correct” values more quickly,simply because inside information is still information. Put another way, it’s not that insider trading is unambiguously inefficient, it’s that we’ve decided as a society that having the right prices isn’t worth it if the system that generates those prices doesn’t operate on a level playing field.