We all know that investing is an exercise in uncertainty. Every time I buy a stock, no matter how confident I am in my analysis, there is a slight moment of anxiety, a tightness in the gut, which whispers, “What if I’m wrong?” I suspect that other professional investors would offer similar stories. Such is the nature of the beast. Wouldn’t it be cool if we could somehow reduce this anxiety, this worry, this uncertainty to zero? Well, there is – it’s called insider trading and it’s illegal.
How illegal you may ask? Well, Raj Rajaratnam, the founder of the hedge fund Galleon Group, was recently convicted of 14 counts of conspiracy and securities fraud because of it. According to news sources, the maximum sentence he could face is 19.5 years. Through the illegal activities for which he has been convicted, he made $63 million dollars. This may seem like a ton of money, but it pales compared to the total size of his hedge fund ($7 billion at its peak) or even his reported net worth of $1.8 billion (again, at the peak). So why would a successful and obviously intelligent guy like Rajaratnam do this? Herein lies the rub…
So, what is insider trading exactly? In its most basic form, it is profiting from a securities transaction when you are in possession of “insider information.” Insider information is simply some bit of data that is “material” and “non-public.” The standard for “material” is that the information has to have the potential to move the stock price. Something like a really good or bad quarterly report or a merger would be examples of this. “Non-public” means that the data has not been released externally, that is, that only “insiders” are in possession of it. So if the president of XYC companies tells you that he is going to buy ABC company for $40 a share and the shares are currently $20, you can make a profit of 100%, risk free by buying ABC now. No risk, only returns.
Insider information is all around us. Four times a year, the senior officers of every public company will possess insider information about their quarterly earnings. Every investment banker, lawyer and corporate office involved in a merger or acquisition will have it. Board of directors of public companies will be privy to strategic discussion that might involve insider information. Clearly, possession of insider information is not illegal. Acting on it is. The laws guiding the use of insider information are very clear, and all persons mentioned above would be fully aware of the obligations to safeguard insider information.
Another interesting aspect of the insider trader laws is that they do not discriminate between the giver and receiver of insider information used to make illegal profits. Both are liable if insider trading occurs. So, if some insider gives material, non-public information to someone who then trades on it, both have violated the law.
Let me return to the question, “Why would an intelligent person do this?” I’m no psychologist, but I think I’ve watched enough television to put together a few possible answers. First of all, money is the big score card for Wall Street. I’ve been told that after the first few million, the money becomes less important as to what it can buy or the lifestyle it can afford, and becomes a marker of one’s status – it’s becomes a defining part of who you are. The more money you make, the more “winning” you are. Second, success often breeds hubris. At some point, the same characteristics that lead to success on Wall Street – brains, drive, ambition, charisma, insight, etc, — especially when coupled with a long, successful track record – can lead to a sense of invulnerability. And, as the proverb suggests, “Pride cometh before the fall.” Those who end up trading on insider information may think that they will never be caught exactly because they are so smart and successful. Third, everyone wants a sure thing. This may be a common trait among all of us.
Recall that when Biff in the “Back to the Future” movie traveled into the future, his only thought was to get a sports almanac so he could go back to the present and make money placing riskless bets on sporting events. I think this resonates with many of us. As much as we would like to think that our time traveling would be spent communing with Newton, or watching the construction of the Great Pyramid, secretly we would really like to go back and buy a bunch of Honus Wagner baseball cards.
If the only sure way to remove all uncertainty in investing is to cheat (trade on insider information), and we don’t want to do that, are there other legal ways to reduce the uncertainty inherent in the process? There are, but alas, they require hard work. To adequately analyze a company’s stock takes time and effort – reading all public information about the company, crunching the numbers, speaking with knowable people about the stock, looking at past trends and developments, creating possible outcome scenarios, and then applying one’s own special intuition and judgment to the mix. Even with all this, some uncertainty will remain. But for some of us, the potential rewards of the exercise, both financially and emotionally, is worth the little bit of angst this uncertainty causes.
And I am sure that the fear of being wrong is much easier to stomach than is the fear of being caught…