How To Avoid Getting Screwed By Big Insider Traders

Raj Rajaratnam

The revelation that the biggest tech hedge fund was allegedly engaged in insider trading with some of the most popularly traded stocks has shocked a lot of investors.

Here’s how to avoid getting screwed by the insiders.

This news comes on the back of the revelation that Goldman Sachs has been holding huddles with its wealthiest clients, especially hedge funds, to give them advanced peaks at Goldman’s views of the markets. Wall Street insiders talking to other Wall Street insiders.

Once again, it seems like the professionals and insiders have a leg up in the market. They have access to all sorts of inside information that regular investors do not. Suddenly, it looks like ordinary investors are at a huge disadvantage.

Here’s the bad news. All of this is largely true. Ordinary investors barely stand a chance when they try to play the markets against the big boys. The odds of an ordinary investor beating the indexes are infintissmal. The odds of beating the hedge fund guys or the prop trading desks of investment banks, especially those with access to information the rest of us cannot get, approach zero.

But this should not be reason to despair or quit investing. In the first place, you can’t afford to quit investing. The interest rate you’ll earn on an ordinary savings account probably won’t be enough to provide for your retirement. And with stocks having gone through a long period of slow to no growth, there are likely to be real long-term profits. (But be cautious, it’s possible that stocks will never go up very much at all, especially after taxes and inflation are taken into account). 

The reassuring news is that it is possible to invest in ways that will protect you from losing out to insider trading and hyper-informed Wall Street and hedge fund traders. That’s why we put together this guide to trading without getting burned by scams, insider trading and other investor pitfalls.

This time you have the opportunity to do it right. So here is our guide to investing wisely and probably even beating the cheats.

Learn how to invest without getting screwed by the insiders >

Buy And Hold Investors Are Not Hurt By Insider Trading

The very best news of all is that long term investors don't get hurt by insider trading at all.

Let's say you invest in a company with a crooked CEO who gives out non-public information about company earnings early to his hedge fund buddies. If you are a long term, buy and hold investor, you aren't really hurt by this at all.

Suppose the information is about how great earnings were this quarter. The insider trading hedge fund manager buys a bunch of shares in advance of the news, and he gets rich when the stock jumps 10% when the earnings are released. The long term investors of the company see exactly the same gain, even though they never had the inside information. And their gain is not one penny lower because someone else bought the shares with inside information.

Now let's say the information is about how terrible the earnings were. Instead, the hedge fund manager shorts a bunch of shares, and he makes a bunch of money when stock dives 10%. Once again, the long term investors are in exactly the same position they would have been in if the insider trading never occurred. They lost 10% that they would have lost anyway.

In both cases, some one was able to profit from insider trading but no harm was done to the long term investors.

The lesson: If you are a buy and hold investor, you already have protection against harm from insider trading.

Prospective Investors Aren't Hurt By Insider Trading..They're Helped!

Even if you don't already own the stock or you are an active trader, you aren't hurt by insider trading. In fact, insider trading is probably helping you by making prices reflect the real health of the company instead of analyst expectations, management lies or misplaced investor enthusiasm.

Let's go back to our example of the CEO who gives a hedge fund buddy information about upcoming earnings results. If that hedgie buys the stock on that tip, the stock's price moves up a bit because there is more buying than there would have been otherwise. Outsiders considering buying or selling the stock are getting a price that more accurately reflects the value of the company than they would have otherwise.

To put it differently, if the insider trading weren't occurring, the outside investors would be buying and selling at a price that didn't reflect the hidden reality. If the inside information is good news, sellers would be selling too low. If it is bad news, buyers would be buying too high. The activity of insider trading actually helps investors by making market prices more efficient.

The lesson: The pricing process of markets means that insider trading is helping you.

No Harm, No Foul

When confronted with these lessons about insider trading, some people will object that they ignore people who sold to or bought from someone who had better information.

There are three groups who fit into this category.

  • The first group is composed of people who sold the stock before good news was released.
  • The second, people who bought the stock before bad news was released.
  • The third, people who didn't buy the stock before the news was released but would have if only they too had inside information.

All the groups are missed out on the gain that the insider traders made. But all three would have missed out on that gain regardless of whether someone else traded the inside information. They weren't induced to sell by the insider--they most likely never talked to the insider at all. There loss wasn't caused by insider trading. It was caused by misreading the prospects of the company.

The lesson: If you try to time the market or predict future results of an individual company, you may get it wrong and lose money. You should probably stop doing that.

Diversified Investors Gain As Much From Insider Trading As They Lose

Despite all this evidence that investors aren't really losing out to insider trading, many people are upset that they don't have the advantages that insiders seem to. They'd like to make the returns insiders can.

Here's the good news: they can!

Insider trading means that investors will sell some stocks that insider traders are buying and buy some stocks that insider traders are selling. On a relative basis, the outsiders will lose out to the insiders. But a diversified investor will be as likely to be on the winning side of these trades as the losing. In short, it all comes out in the wash known as the market process.

The lesson: You are as likely to win from insider trading as you are to lose. Over time and across a broad portfolio, it nets out.

Diversify, Diversify, Diversify

Obviously, the thing you need to do to avoid losing out to those insider traders is diversify. This sounds easy but it is actually quite difficult. Here are some pointers on how to effectively diversify.

Asset Mix. You are not diversified if you own 20 stocks or even a hundred stocks but nothing else. You need a variety of assets classes--stocks, bonds, gold, Treasuries--to truly diversify.

Time preference. You portfolio should also contain assets that you expect will appreciate along different time lines. This is important, and widely overlooked. This will help you avoid having all your investments keyed to one time--a time when the market could be crashing.

Have More Than One Manager. The clients of Bernie Madoff believed they were diversified because they had so many different kinds of assets listed on their monthly statements. But many of them were exposed to a different kind of risk--the risk of getting ripped off by their asset manager. It's not just outright thievery you need to worry about--investment managers can fail and take your portfolio with them.

The lesson: diversification needs to happen at every level.

Engage In Insider Trading (Legally)

More good news: you can use inside information too!

If you have a very important piece of information about the market or a company that no one else has, you should consider trading on that information. There's nothing illegal about trading on secret information that you discovered through your own hard work or just dumb luck. In fact, this is one of the only ways anyone can ever beat the market.

Here's the catch: Don't do this if the information is about a company you work for or your spouse works for. And don't even do this if you have an obligatioon to another third party, like if you work for a financial publication that's about to write a favourable article about a company. If you got the information from someone related to you or who expects to gain from your trading, be aware that that also could violate SEC rules governing trading on non-public information. If you are uncertain, talk to a lawyer (who will probably tell you not to do it) or just don't trade.

But don't fall prey to the common misconception that you cannot trade on non-public information. You can and you should.

The lesson: Having knowledge that others lack is a very, very good investment strategy.

But Don't Get Cocky With Your Inside Information!

Sometimes even when you have inside information, you can get burned.

This is one of the key lessons from the recent Galleon insider trading scandal. At one point, Galleon allegedly received information that a tech company's earnings were going to be poor. It shorted the stock. If everything had gone according to plan, Galleon should have been able to see a nice profit on the trade.

But things didn't go according to plan. The tech company announced that it was being acquired by a bigger player, sending the stock soaring. The inside information about earnings was irrelevant. Galleon got clobbered on the trade, losing so much that it erased any gains it made on any other alleged insider trading.

The lesson: Timing the market and forecasting performance is dangerous even if you have non-public information.

Don't Fall For The Hype About The Level Playing Field

The playing field in the market is never level.

Investor confidence built on the idea that regulators can create a level playing field is no better than a con game. Instead of trying to foster investor confidence around this phony notion, the SEC should sanction anyone they find fooling investors into believing it.

The truth is that the ordinary, retail investor is like the high school JV team playing against the New York Giants. You don't stand a chance if you try to beat them at their game of stock picking, forecasting and market timing.

The lesson: If someone tells you the playing field is level, get off their field and play somewhere else.

Insider Trading Sanctions Help The Stock Exchanges And The Brokers But Not You

The main effect of criminalizing insider trading is that it creates investors confidence that the markets are safe to invest in. This is a false confidence that only hurts investors.

It benefits brokerages, stock exchanges and companies issuing shares, however. It turns out, investors will probably trade more and put more money into stocks if they are convinced that they aren't at a disadvantage. And this is probably the main reason insider trading is prohibitted: to protect the interests of the ultimate insiders. Ironic, isn't it?

The truth is that even if all insider trading were banned, the market would be rife with informational asymmetries that may give advantages to bigger players. But most of these asymmetries are invisible to ordinary investors. By going after only the visible asymmetries, the regulators convey a false view of the market.

The lesson: The lies about level playing fields only helps insiders and hurts outsider.

More Good News: Efficient Markets Mean Even Insiders Have Trouble Profiting

The great news is that despite the asymmetrical information in the market, the opportunities to profit from it are very limited. Too many people are engaged in the pursuit of 'the edge,' which means that the odds of discovering some bit of information that no one else has is very slight. And once that information is discovered, savvy traders note the price of stocks moving and trade based on assumed inside information.

Which is to say, the market doesn't hold out huge rewards for people with inside information. Even when the big boys profit from having an edge when it comes to knowledge, a lot of this is just luck.

The lesson: Market efficiency is working for you and not the insiders!

Fight High Investing Costs

There is one way that insiders on Wall Street can definitely crush you in the markets: they get you pay too much to invest. High costs of stock brokers, financial advisers, tax consultants and even mutual funds can completely destroy any gains in your investment portfolio. If you cannot figure out how to control your costs, you really might be better out not investing at all.

The entire business of Wall Street often seems organised to hide the costs of investing from you. The fees are often written in small print on your quarterly statements, and you probably will have a hard time understanding them. No one will ever ask you to approve each fee after it is carefully explained to you. You don't have to initial any boxes authorizing each fee you will be charged.

So here's how to address this problem: if you can't figure out what fees you are being charged, you should not use that service to invest. Whether it is a brokerage account in which you buy and sell individual stocks or a mutual fund that does this for you, if the fees are transparent and understandable, avoid it.

Here are the four major sources of investing costs you should watch out for:

Brokerage Commissions. Every time you buy and sell a stock, your brokerage probably charges you a fee. Often these are flat fees, based on either the trade or the amount of stock purchased. Regardless of the way the fee is charged, the rule is the same: the lower the better.

Advisory Fees. Brokers and mutual funds will charge you a fractional amount based on the size of your portfolio. Often the number is small enough that you might not think it is a big deal to pay something as small as 2% but these costs add up quickly. In some flat years, that will eat away at all your market gains. In down years--and there are always down years--you'll end up paying more than your earned. Together, the flat and down year fees can add up to more than the gains in a bull market.

Taxes. When your investment adviser tells you how much money you've made for the year by investing with him, he's probably talking about pre-tax gains. But here's the thing. You never get to pocket pre-tax gains. You pocket after-tax gains. That means you need to know how the tax system will treat the investments you make. And you need to anticipate what future developments in the tax code will be.

Inflation. This is the ultimate killer. If your investment gains don't outpace inflation, you're actually losing money in the long term as the value of your money gets eaten away.

The lesson: Know what it costs you to invest!

Screw Wall Street Before It Screws You

Now that you know the costs that can tear into your portfolio, you need to find ways to reduce them. Here are five things you can do:

Invest in the lowest cost mutual and index funds available. This seems like a no-brainer. But many investors over look it. Tiny fractions of a per cent can make a big difference over the years.

Pay Attention To Changing Costs. Just because you invested in a low cost fund to start, doesn't mean the costs stay low. New products and competitors may have been introduced, and your fees may have increased. The price of Wall Street's feedom is your undying vigilance.

Pay Capital Gains Not Income Taxes On Investments. An actively investing fund or a brokerage account with frequent sales generates a lot of high taxes on gains. You can reduce the cost of taxes by going with a passive fund that makes long-term investments. These pay lower capital gains taxes, instead of ordinary income taxes. But beware: there are some on Capitol Hill who would like to eliminate this benefit.

Invest Through A Retirement Account. If you are saving for retirement, make sure that you are using an account that has legal tax advantages that allows you avoid taxes now or in the future. This is a huge advantage. Most big employers will offer these accounts to you.

Buy Inflation Protected Treasuries. There are lots of opinions about how to reduce your exposure to inflation. Some people will tell you to buy gold, which tends to go up when the value of money goes down. This isn't practical for most investors. A far easier way it to put part of your portfolio into TIPS--short for Treasury Inflation Protected Securities. This won't protect you if the government of the United States collapses or repudiates its debt. But if that happens you'll have a lot more to worry about than the effect of inflation on your portfolio.

Expose Yourself To Upside Surprises

The typical Wall Street financial analyst will put you in the same kind of portfolio he puts everyone else like you into. In fact, he's more or less required to do this by the laws which say he can only recommend appropriate strategies and products.

Fortunately, you aren't required to follow their advice.

One thing we've learned is that the markets are unpredictable. Even studies that show gains in the broad market through history cannot tell us for certain what will happen in the future. In fact, there's a lot of recent evidence that we're underestimating the uncertainty of the future.

That's a problem for investors because you cannot invest in the past. You can only invest now for gains you hope to make in the future. In short, you are always speculating on uncertain future events.

One way of handling the radical uncertainty of the future is to create upside exposure to really uncertain events. This means that you have to be willing to put some money down on one number on the roulette wheel. Don't be a fool and make a huge bet and don't do it completely randomly.

Here's what you should do. Find an event that looks really unlikely in the future. Something everyone you ask tells you is almost certain not to happen. Make a small investment in that event happening. But be sure that the odds against you.

Let's use an example. Buying a lottery ticket for a dollar isn't a good way to exposing yourself to the upside of winning because the initial investment of a dollar is too much for almost any imagine jackpot. But if you could buy that lottery ticket for a few pennies, it would make sense.

The lesson: risky bets are fine if the cost of making them is low enough.

Limit Your Exposure To Downside Surprises

Beware Of Your Own Riskiness

Here's another way you can get screwed by Wall Street insiders: they might decide you are too risky.

This can happen to anyone, even the biggest players. Let's take AIG as an example. It had insured billions of dollars of subprime mortgages, and it thought it would be safe because most of those would still be in the money even if the housing market tanked. So far, that's still true. But what killed AIG was that as both the risk on those mortgages increased and the perception of the riskiness of AIG itself grew, it's customers had the right to demand more money as collateral for the insurance policies they bought. AIG couldn't afford to put up the collateral, which is why it went hat in hand to Uncle Sam.

AIG never considered the risk that its customers would demand more collateral. You shouldn't be that dumb. While you aren't selling derivatives, there are lots of ways you could find yourself squeezed into having to sell assets at the very worst time. If you don't have enough cash on hand, you might find yourself having to sell stocks during a bear market to pay for your mortgage. If you bought in a margin account, you might get squeezed by your broker.

Overall, remember that you are exposed not just to your investments going up and down, but to other demands on your assets that could force you to sell investments when you don't want to. Resist pressure to 'fully invest' and keep some liquidity on the sidelines for these events.

The lesson: Stay liquid so Wall Street can't squeeze you.

Read Your Quarterly Statement. Ignore Most Of It.

No one likes to read the statements from their financial statements when the market is down. They're ugly. They make you feel stupid. They make you feel poor.

But you need to read your statements. Just not for the reasons most people think. You shouldn't read them for the returns from the last quarter. That's just noise that may make you panic and sell at the wrong time.

You need to read them to keep track of the fees. Believe it or not, some funds and brokerages know that people don't read statements during bear markets and they will raise fees during that time hoping investors won't notice. So read the fees section and ignore the returns.

These fees, not insider trading, is the main way Wall Street insiders screw the outsiders.

The lesson: Pay attention to what fees you are paying.

You Can Negotiate Anything

If you are signing on to a big mutual fund, you will have to pay the fees they require. (Remember: most mutual funds are rip-offs, so only go with low fee funds.) But if you are opening a brokerage account, you will have room to negotiate your fees.

Financial advisers will tell you that the fees are fixed. They'll say that they can't change them. They'll show you where this is all written down.

Don't believe them.

There are many different fees brokerages offer, and they are not obligated to give you the cheapest one. The rules just say it must be appropriate to you. You should haggle with your broker to get the lowest fee you can.

When they give you a quote on the fees, start by telling them: 'These aren't the fees I'm looking for.'

Invest In Low Cost, Passively Managed Life Cycle Funds. Reinvest Your Dividends.

You Can't Beat The Market And You Don't Want To

Now here are the four most important things you should know.

Insider Trading Isn't Hurting You. As long as you aren't playing the hedge fund game and competing with them on a relative basis, you aren't being hurt by insider trading. In fact, you are probably being helped out because the markets are more efficient.

You can't beat the market. If you were hoping that you'd learn how to 'beat the market' by reading this investment advice, you'll be sorely disappointed. Nothing here will help you beat the market. At best, if will help you not fall too behind the market. Very few people can actually beat the market--and most who do just got lucky.

You don't really want to beat the market anyway. The good news is that you don't have to beat the market. That's actually a pretty arbitrary measure. What you really want to do is save some of your money for later, and not let it lose value thanks to the passage of time and the cummulative effect of inflation. That's your real goal with investing. Not beating something or someone. Not getting rich quick. It's investing prudently for the future.

Returns Might Be Worse Than You Expect. In the past, diversified investing strategies have paid off moderately well even after taxes and inflation. But in the future this might not hold true. In fact, because of demographic changes, changes in the spread of information, changes in the age of the average investor, and a decade of stagnant or declining stock markets, we may be in for a long bear market. Spikes will reward the lucky market timers, and you may occasionally get lucky. But don't count on stocks or bonds to go up along historical trend lines forever.

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