Insider Trading — dumb money guru (2024)

Introduction

In our post on the Efficient Market Theory we mentioned the fact that stock prices reflect all publicly available information, and that stock prices only react to new information. With that being the case, if you want to get a leg-up over the competition, you’ll need to get access to information that nobody else has! If you know something about a company that nobody else on Wall Street knows, you’ll be able to make a more informed decision about whether or not to invest. Although we discuss a few ways that you can do this legally in other posts, let’s first look at a few illegal ways that some people have tried to do this.

Insider Trading Is Illegal

One method for accessing information that nobody else has is called insider trading; and it’s illegal. Insider trading is when you buy or sell shares of stock, based on information you received from someone inside the company. The key thing to mention here, is that the information you received must not publicly available, to qualify as insider trading.

Does This Count As Insider Trading?

Remember what we’ve been saying. Share prices will consistently reflect all information that is publicly available. However, if you can get a stock tip from a source within the company, then you can get ahead of the price movement of that stock. Here’s an example.

Let’s say that you work at ABC Company and overhear the CFO talking on the phone. During that conversation, you heard the CFO say that he was just in a meeting with the company’s board of trustees. And that he told them the company is headed for ruin. Specifically, you overheard the CFO saying that ABC Company is being sued by several multinational corporations, and that ABC Company is also set to release an abysmal earnings report at the end of the week. Oh! And by the way, ABC Company will probably have to declare bankruptcy in the next few months as well. You know that your friend Amanda owns stock in ABC Company. So, ou rush out of the office to call and warn her, that she should sell all her shares. Since this news hasn’t been publicly released, your actions - telling Amanda to sell all her shares - would be considered insider trading, and it could get you hefty fines and jail time.

Some History And Background

There’s been a long history of insider trading in the United States. The first case dates all the way back to 1909. More recent cases of insider trading exist too. In fact, from 2001 to 2006 alone, there were about 300 charges of insider trading brought against more than 600 people, including Larry Ellison, the CEO of Oracle, and Jeffrey Skilling of the Texas-based energy company Enron.

Who Investigates Insider Trading?

The Securities and Exchange Commission (SEC) is the governing body in charge of regulating and enforcing insider trading rules. Since they have access to - and can monitor - every single stock trade that’s placed, it’s relatively easy for them to identify potential cases of insider trading. Every time a major stock order is placed, prior to a big jump in stock price, there’s the potential for insider trading. And these anomalies, or unusual activity in the trading patterns of a specific stock, are what causes regulators to start asking questions. However, gathering enough evidence to build, prove, and win an insider trading case is difficult.

Why Cases Get Dropped

In our earlier example, you overheard the CFO talking on the phone about the ABC Company’s recent board meeting, and then you advised your friend Amanda to sell her stock in the company. If the CFO didn’t directly tell you that information and there’s no documented evidence of how you (the employee) might’ve heard it, the SEC would have to see the trade, become suspicious, and then link your friend Amanda’s trade to you (the employee) who works at the company in question. They would have to uncover how you (the employee) became privy to the information that the company was going under. Since there’s no paper trail, or proof of anyone witnessing you overhearing the conversation, this would be almost impossible for the SEC to prove. As a result, you can see how catching people who are involved with insider trading, is much easier said than done.

Even if the investigators are almost positive that something illegal happened, they’ll still need to gather evidence and prove it in a court of law. And, in some cases, even when there is an abundance of evidence, the case may be too small monetarily to make it a worth prosecuting. In other words, the amount of money involved might mean that it would cost more money to prosecute the case, than the amount of involved that the guilty party is accused of trading or benefitting from. This is especially true, if the guilty party admits upfront to doing something illegal and is willing to face the consequences (e.g. losing their Series 6, 7 or 63 securities trading licenses, being barred from holding a leadership position in any other publicly held companies, or perhaps being willing to pay fines and restitution).

Public Figures Do It Too

By the way, insider trading isn’t limited to only private citizens. Public figures can also fall into the temptation of making easy money. An example of this happened in early 2020. It involved several U.S. senators, both Democrats and Republicans. The senators were supposedly briefed on the coronavirus pandemic before the public was notified; they were made aware of how severe it was going to be. This prompted several of them to call their financial advisors to start the process of selling off large portions of their portfolio - all this in anticipation of a major stock market collapse. Since it looked like the senators acted on information that wasn’t available to the public, they were placed under investigation for about a year. Ultimately, there wasn’t enough evidence to build a case against these senators that could be won in court. All the charges were later dropped.

Another pretty notable example of insider trading involved a high-profile but unlikely name: Martha Stewart. You’ve probably heard of the case. Martha Stewart is an American businesswoman, writer, TV personality and the founder of Martha Stewart Living Omnimedia. In 2001, she was a major investor in a pharmaceutical company called ImClone, that was waiting on FDA approval for a new cancer drug. The FDA didn’t approve the drug, and ImClone’s stock quickly dropped. Although the price drop hurt many investors, friends and family of the CEO (Samuel Waksal) all escaped unharmed. It came out later, that Martha had sold 4,000 shares of the company, just days before the price dropped from $50 to $10. She had acted on a tip from the CEO. Her charges of insider trading were eventually dropped, but she was sentenced to five months in prison for obstruction of justice and conspiracy.

Alternative To Insider Trading

Was it worth it to Martha? We highly doubt it. We’re sure she wishes that she had just tried to beat the average return of the stock market legally. You might be wondering (yet again), “is that even possible?” Although we’ve repeatedly answered “no” to that question, there are cases where people have done it legally. Usually, the people who are successful at outperforming the market do so by staying away from insider trading, and instead taking advantage of a single, ultra-high performing asset. For example, take a look at the following gains for four investments.:

1. Apple ($AAPL) - 1600% from $7 to $127 (including a stock split) during 2010-2020

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2. Netflix ($NFLX) - 6500% from $7 to $500 during 2010-2020

3. Tesla ($TSLA) - 967% from $65 to $665 (including a stock split) during 2018-2021

4. Bitcoin - 12,173% from $457 to $55,000 during 2016-2021

From 2010-2020, the stock market had a return of 265%. Comparatively speaking, this means that a stake in any of those four assets would have easily outperformed the stock market. There are likely countless other success stories that are just not made public. For example, many of the people who were early investors in these companies (e.g. the company’s first employees, or venture capitalist firms) are likely millionaires now due to each company’s success. Although these stories might give you confidence to try to become another positive success story, let us be the first to advise you, not to waste your time.

Conclusion

You’d be much better off, simply investing in an exchange traded fund and allow the stock market to bring you a respectable 10% return every year. If you don’t like those odds, you could always go the insider trading route; but we wouldn’t recommend it.

References

1. https://www.encyclopedia.com/social-sciences-and-law/economics-business-and-labor/money-banking-and-investment/insider-trading#:~:text=The%20first%20known%20prosecution%20for,going%20to%20jump%20in%20price.

2. https://www.encyclopedia.com/social-sciences-and-law/economics-business-and-labor/money-banking-and-investment/insider-trading

3. https://www.wsj.com/articles/justice-department-closing-insider-trading-investigations-into-three-u-s-senators-11590520934

4. https://www.thoughtco.com/martha-stewarts-insider-trading-case-1146196

5. https://www.google.com/finance/quote/AAPL:NASDAQ?window=MAX

6. https://www.google.com/finance/quote/NFLX:NASDAQ?window=MAX

7. https://www.google.com/finance/quote/TSLA:NASDAQ?window=MAX

8. https://www.google.com/finance/quote/BTC-USD?window=MAX

9. https://www.google.com/finance/quote/.INX:INDEXSP?window=MAX