Insider trading is illegal. It can easily be summarised as an individual buying/selling shares based on knowledge that they have managed to obtain that isn’t available publicly.
For instance, say that an investor found out that company X was going to be taken over Company Y, but this knowledge was not in the public domain, and then they bought shares in Company Y, this would be illegal insider trading.
I’ve always wondered about this. Everyone talks, right? And I’m pretty sure that these “city workers” have a lot more information than I do. And people are generally greedy?
Therefore, I would imagine that a lot of individuals, and more importantly large fund managers, are privy to non-public information that they could profit from. Equally, with the pressure for them to achieve good results, and the general environment they find themselves in, it wouldn’t surprise me at all if insider trading was absolutely endemic.
So, today I want to have a quick look at what insider trading is, how common it is and what impact it has on the common (and honest) investor.
Insider trading actually doesn’t matter for the passive investor
The good news is that insider trading has absolutely no impact on the passive investor. If we, as Moneystepper suggests, buy low-fee market tracking funds or ETFs, it doesn’t matter if some sly dog buys shares in a company which is about to release record results or about to be taken over.
However, for other people who try to invest in individual stocks, this might be costly. For example, say company A is going to be taken over in 1 month and no-one outside of the two companies currently knows this information.
If a number of insiders buy the share based on insider trading, it’s likely the share price will increase. Say the original share price was £1 per share. Then, based on the insider knowledge, the share price increases to £1.05.
The individual investor (not an insider) then buys the share at this price. Once the information goes public, the share price increases to £1.155.
In this example, this individual investor gains 10%, but if they had invested at the price which wasn’t impacted by the insiders, they would have had a 15.5% gain.
But, how common is insider trading and what impact does it have on the companies’ share prices.
How common is insider trading?
Well, it would seem that it’s fairly common, as I would expect it to be. A Yahoo! Finance article from mid-2014, which analysed research from NYU’s Stern School of Business, concluded that evidence of trading on non-public information was found in one quarter of merger-and-acquisition transactions between 1996 and 2012.
What the report doesn’t conclude on is the impact that this insider trading has on the share price.
For example, if a consultant advising Apple on a possible purchase of Microsoft buys 500 shares of Microsoft, this clearly has no impact on the share price of either company, but might be picked up in the study above.
Is there any evidence of insider trading in the price of shares?
To determine the impact of insider trading on the price of shares, I have taken the best performing shares of 2014 from the FTSE 350 and then selected the best day where these shares had their best performance of the year!
Then, we noted the performance of the stock in the 5 days before the best performance day, compared to the average 5 day performance throughout the year.
The idea is that if Company B are about to release results way ahead of market expectation, the share price on one day will shoot up. If there was rife insider trading which impacts the share price, we would then expect the price in the 5 days prior to exceed the average.
The results may surprise you:
The actual average performance on the five days before the monster day of performance was -0.5%. This compares to an average 5-day performance in these shares of 1.3%.
Now, I know that this sample size is ridiculously small. However, what is it does have going for it is:
- Its focused. These are the best performing shares which indicated the biggest news and therefore the greatest incentive for insiders to trade on any information they have.
- ..but also varied. Additionally, the reasons for the increase vary from results, drugs being approved, director deals, and M&A activity.
What can we conclude about insider trading?
Well, the information above would suggest that, whilst it may be fairly common, insider trading probably has very little impact on investors overall (and no impact on passive investors like myself). That’s a relief to know…