Investment Intelligence from Insider Trading
Miller, Edward M., The Journal of Social, Political, and Economic Studies
A recent book analyzing a large database about "insider trading" as reported to the Securities and Exchange Commission gives valuable insights into what can be learned, by investors and market analysts, from the buying and selling done by insiders. In this article, the book's results are reported, and commentary is added about the implications.
Key Words: Insider trading, market indicators for investors, H. Ne)jats Seyhun, insiders' market behavior, statistical studies to predict securities market.
H. Neyjats Seyhun's Investment Intelligence from Insider Trading (MIT Press, 1998) reports on a massive study of the ability of statistics on insider trading from 1973 to 1994 to predict U.S. stock returns. It should be of interest to both stock market investors and financial economists.
The federal Securities Exchange Act of 1934 defines "insider" in two ways, one of which says insiders are high-level corporate executives, board members, or stockholders with over 10% ownership in the company. Insiders of this kind are forbidden from benefiting from any positions held for less than six months, and anyone in possession of material, non-public information (the other definition of "insider") is forbidden from trading in the firm's securities while having such information. To enforce these regulations, insiders of the first type are required to report their trading of the stocks for which they are insiders within 10 days of the month's close to the Securities and Exchange Commission, which then makes it public. Seyhun combines this data with other stock market data to also report on the profitability of investment rules involving such measures as priceearnings ratios, book-to-market ratios, take-overs, and trends in prices.
In Seyhun's study, insider trading in a particular company is first aggregated by months, with a month where the insiders bought more shares than they sold defined as a buying month, and one in which they sold more than they bought being defined as a selling month. This resulted in 144,884 buy months and 164,309 sell months, making this a large database. The surplus of selling is probably because the category of insider includes many who started firms (or got in early), and who afterwards tend to be net sellers. Since most insiders have the bulk of their wealth in their company, standard financial advice would be to diversify (which of course is legal). It should be noted that much insider trading is for such legitimate purposes as diversification and personal liquidity. It is also legal for insiders to make trades based on public information (if, at the time, they have no inside material information). Of course, given their concentrated position and incentive to keep up-to-date on their companies, insiders may be better able to evaluate and use the public information.
While it is illegal for insiders to trade on material, non-public information, it is legal to refrain from trading on the basis of material, non-public information, a point Seyhun does not make. To illustrate, consider an individual who has a substantial position in a company (perhaps from being a founder, or from having exercised many options). Having little invested outside of this company, he decides to diversify his investments by selling a portion every quarter, carefully timed so that he is not selling when he has material, non-public information (such as an unusually bad forthcoming earning announcement). This is a very sensible, rational policy most financial planners would approve of, Now suppose this insider receives non-public information that the company's earnings will be unusually good this quarter (or even that the company is negotiating to be taken over at a big premium). The insider is legally free to cancel his planned (but probably unrevealed) sales, making them later when the price is likely to be higher. Since he has used his insider information not to trade at a profit, but to avoid trading when he had material information, he has not engaged in illegal insider trading, although he has still benefited from his inside information. …