David R. Henderson  

Who Loses from Insider Trading?

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In one of this month's two Feature Articles, "Who Is Harmed by Insider Trading?", Charles L. Hooper takes a look at insider trading. Specifically, whom does it hurt.

A key paragraph:

Insider "hurt" Uninformed Buyer by nabbing Uninformed Buyer's unexpected and unearned windfall. How can Insider be less deserving than someone who isn't deserving at all? Insider, after all, is making the stock market more efficient by disseminating important information, while Uninformed Buyer's actions are equivalent to background noise.

Read the whole thing.


Comments and Sharing






COMMENTS (43 to date)
MikeP writes:

Insider trading "hurts" professional traders who are in a position to get public information first and leverage it most rapidly.

For every other trader it is a wash. For the market it is a positive as more information is made more available more quickly.

So, just as one would expect, insider trading laws are yet another form of corporate welfare for the well-connected rich.

John hare writes:

Read it and still don't buy it, just as I didn't buy it last time it was posted. My true opinion would be moderated for rudeness and language. It's like saying someone stealing small amounts from the poker pot doesn't harm anyone as the true winner was not deserving either.

David R. Henderson writes:

@John hare,
This is the first time it is posted. It posted only an hour or so ago. The key problem with your analogy is that insider trading is not anything like theft. If the corporation’s rules allow insider trading, then the insider is not breaking the corporation’s rules. The SEC should stay out.

Zeke writes:

I am generally sympathetic to Charles Hooper's position, however he seems to be only looking at this from the perspective of trading. Isn't there a potential agency cost issue here?

The law of agency developed to try to prevent agents from deriving benefits from the P-A relationship outside of the agreed upon price P pays A to be P's agent, precisely because of the agency problem -- there is a fear A will act in A's interest at the expense of P.

Legalizing insider trading may encourage abuses by corporation's agents, as they attempt to create situations wherein they can benefit from insider knowledge. Of course, corporations themselves can attempt to solve this by passing binding prohibition of insiders trading in their corporation's stock, but that would likely have to happen at the SH level, which faces a collective action problem. Further, there are a lot of ways insiders could sub-optimally steer a corporation in order to get insider returns that are unrelated to stock in the corporation per se.

Corporate law would not be a good salve to this problem, as the BJR (rightfully) is deferential towards the Board and Management.

So, perhaps insider trading harms corporate values by encouraging managers to pursue their own interests at the expense of SHs. In this way, Insider Trading isn't really about criminal law, but instead is (an albeit clumsy) solution to this difficult agency problem.

David R. Henderson writes:

@Zeke,
Of course, corporations themselves can attempt to solve this by passing binding prohibition of insiders trading in their corporation's stock, but that would likely have to happen at the SH level, which faces a collective action problem.
That suggests another solution: have a general prohibition against insider trading unless 50% plus 1 of the shareholders vote against. That way, the collective action problem works (or fails to work) the other way.

Zeke writes:

Prof. Henderson,

Clever solution to the potential problem I highlighted. Basically, allow an opt-in instead of an opt-out.

John hare writes:

There was another defense of insiders someonths ago. The insider has reduced the average roi of the rest of the traders. I do not support a government solution preferring a market solution. iPhone comment short. Will explains position this pm.

David R. Henderson writes:

@Zeke,
Clever solution to the potential problem I highlighted. Basically, allow an opt-in instead of an opt-out.
Exactly, and thanks.
I think one could argue that the threshold should be lower than 50%, precisely because of the collective action problem. Possibly 40%?

Jeff writes:

This is nuts. Insider trading implies that investors are suckers to be fleeced. You might as well just shut down the stock markets and be done with it, as no one is going to be able to raise capital through them once everyone catches on. Then there will be no traders, inside or otherwise. Is that really the desired outcome?

David R. Henderson writes:

@Jeff,
Can you honestly say that you read the whole article?

Zeke writes:

Jeff, your position is somewhat self-defeating given that a lot of insider trading is already legal. Pretend I am an insider in Corp. A. Corp. A decides to buyout Corp. B, of which I own some stock. Let's say I decided I wanted to buy stock in Corporation X. In order to finance this transaction, I was going to call my broker and tell him to sell Corp. B and buy Corp. X. But before work closes, I receive info that Corp. A is going to buy Corp. B. Therefore, I never call my broker. I get the windfall when Corp. B announces that Corp. A is purchasing Corp. B.

How is that qualitatively different than the following scenario. Same facts, except I don't own Corp. B stock. I am going to use cash to buy Corp. X stock. Prior to my purchase, I obtain information about Corp. A's purchase of Corp. B. I then call my broker and buy Corp. B stock instead of Corp. X stock, and reap the benefit of my insider knowledge.

It seems to me these two situations are the exact same, but one is illegal and the other is not (I believe). So, if some insider trading does not cause destruction of capital markets, why would a bit more insider trading cause this destruction?

Prof. Henderson:

50% + 1 is what is traditional for Dela. SH bylaws (some require super majorities). So, while conceptually I don't have a problem with 40%, it makes sense to me to go with the weight of tradition.

Nonetheless, it would be fascinating to see what would happen when some corporations would allow insider trading and others would not. Which corporation would face harder credit/equity markets? Which one would have to pay more for executives? Would executives be marketable after going to an "insider-trading" firm or would they be "tainted?"

Jeff writes:

@David,

I had not read the whole article before commenting because I've seen this argument before. But after seeing your comment, I have now read it all, and my opinion is unchanged. This is an old argument, and it still fails.

The Uninformed Buyer may or may not be "deserving", but as Will Munny (Clint Eastwood's character in Unforgiven) said, "Deserve's got nothin' to do with it." Who "deserves" to win a poker hand? No one. But not many people are going to play in a poker game they know is rigged against them. If you want to have a long-running game with a lot of participation, you're going to have to run an honest game.


Charley Hooper writes:

@Jeff,

Consider the following:

- Most investors are never affected by insider trading because they buy and hold for long periods. The only time insiders could have been active in the Cubist example was during that short period when Merck and Cubist were in closed-door negotiations. Very few people are directly affected by insider trading.

- @Zeke has already raised another point, which is that 83 percent of potential insider trading scenarios can never be prosecuted, even with an SEC cop following every investor 24/7.

- Insiders make the stock market more efficient. Efficiency helps those who want to raise capital.

- Market professions already trade as quasi-insiders, with complete legal immunity.

- Insider trading laws have been pushed onto international stock markets by the U.S. government to make it easier to prosecute Americans who engage in insider trading. In many of those markets, which work quite well, insider trading was and continues to be prevalent.

Jeff writes:

Insiders may or may not make the market more efficient. It's true that their trades do reveal some information sooner than it otherwise would be revealed, but how much information discovery by non-insider traders is discouraged when insider trading is allowed? Why work hard to uncover fundamentals and try to figure out which stocks are undervalued when the inside traders are going to steal some of the profits you might have made by doing so?

Why do you think that buy and hold investors are unaffected? I buy index funds for my 401K, and that's about as buy-and-hold as you can get. If total market returns are not affected by insider trades, then the profits they make have to be coming at the expense of the overall market. As an index fund holder, that's me.

Lots of murders go unsolved. I don't think that means we shouldn't prosecute the killers that are caught, do you?

Rick Hull writes:

Jeff,

There is another angle you may be unaware of: The premise that the general public is protected from insider trading is utterly false. Insider trading, information asymmetry, going up against informed traders... These are the facts of life.

Many defenders of insider trading protections and prohibitions defend their view as convincing the general public to trade when they might otherwise hesitate. The cynical view says this is just a ploy to fleece the general public.

Only very few and certain forms of insider trading forms may be prohibited, let alone enforced. It is better to accept reality and let the chips fall where they may than to present a fantasy view and provide false comfort.

Tom West writes:

investors who lose when insiders trade are even less deserving of the windfall profits than the insiders themselves.

I consider that someone who buys a lottery ticket deserves the win if they get it, and a shop keeper who hoodwinks someone into selling the winning ticket for a pittance is acting unethically.

And once insider trading is completely acceptable, I would assume that the market would provide appropriate financing to assure that insiders would reap almost all windfall profits.

It would also make corporate governance interesting, where there'd be strong personal motivation to engage in transactions that provide massive changes in stock prices that insiders could take advantage of.

Of course, I could be wrong. Are there any examples of successful stock markets where insider trading is utterly unrestricted and enough time has passed to create the financial mechanisms to take advantage of this?

Charley Hooper writes:

@Zeke,

The principal-agent problem will always be present. However, I don't see it being a problem in examples like this.

Those on the Cubist negotiating team were already invested heavily in Cubist stock (it's hard to work for a company like Cubist and not end up with lots of shares and options) and strongly wanted the deal to go through.

Both of the Merck and Cubist teams were comprised of members who had far more to gain from a successful deal and the appearance of helping their employers than from trading and potentially ruining the deal (these deals are often touch-and-go) or later being found to have "selfishly" traded and therefore compromised the company's position.

Successful deals lead to kudos, bonuses, promotions, bragging rights, and burnished resumes. Messing with a deal could lead to termination and a rough job search.

Phil writes:

I am not going to comment on the economics of insider trading, but I will take issue with the author reaching his conclusions from a case that does not address those points. This is not a case about trading by an insider. It is a case about someone who came to hold inside information, shared that information without revealing it was inside information, and did not benefit from the disclosure. No one here traded on inside information, hence the acquittal. This is not new law, nor anything novel. The issues were settled in Dirks v. SEC, 463 U.S. 646 (1983).

Here's a critically important quote from the case: "Newman and Chiasson [the defendants] were several steps removed from the corporate insiders and there was no evidence that either was aware of the source of the inside information."

Charley Hooper writes:

@Zeke,

The principal-agent problem will always be present. However, in examples like this, I don’t think it’s a significant problem.

Those on the Cubist negotiating team were already invested in Cubist stock (it’s hard to work at a company like Cubist and not end up with shares and options) and strongly wanted to deal to succeed.

Both the Merck and Cubist teams were comprised of members with far more to gain from a successful deal than from trading as insiders and potentially derailing the deal (these deals are often touch-and-go) or later being found to have made “selfish” trades and, therefore, not acted in the best interest of their employers.

Successful deals lead to kudos, bonuses, promotions, bragging rights, and burnished resumes. Messing with a deal like this could lead to termination and a rough job search.

Dan writes:

Jeff is right. This is a standard result in economics. Information asymmetry will result in lower liquidity, larger premiums, and in extreme, complete market failure.

How large the effect depends on the degree of the asymmetry, number of repeated interactions, prevalence of insider trading, etc.

It's an empirical question (a very difficult empirical question to quantify), and in no way is there a consensus that the effect on the markets is small.

See for instance:

https://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2005/BD_The_world.pdf

Ray Lopez writes:

Jeff's argument that liquidity will dry up if the market is rigged is in fact mainstream SEC logic. Against this, some stock markets (I think Saudi Arabia is one of them) allow insider trading and they still function. Also in fact insider trading is common in the USA (an academic study found prior to mergers being announced there was a spike in prices). I think the main damage by inside trading is that it drives up the price for certain parties in an acquisition (that's why acquiring companies keep such acquisitions secret, as I can attest having been involved in some) but from a "Coase theorem" point of view, society is not harmed. Still, as Jeff points out, from an ethical point of view it doesn't feel right to have inside trading (though I myself am for it) and I hate those law cases where the tippee did not profit but still gets nailed for being a conduit--that seems unfair. In a way, inside trading is like front running (trading in front of a large client's big stock order), knowing that the client's order will move the market. If front running exists, it has the potential to disrupt the market, though in fact a big company can simply contractually require the broker to not front run, or use 'dark pools' where there is less of such front running in theory (since orders are matched in bigger blocks between big companies).

All in all, much ado about nothing, but it is a favorite Libertarian hobby horse.

Charley Hooper writes:

@Tom West,

Your lottery ticket example isn't appropriate. Once the purchase has been made, of course, the owner deserves the payout. And no one is doing any hoodwinking.

A more appropriate example would be where the original lottery ticket purchaser decides, at the last minute, not to purchase the lottery ticket and then feels cheated by missing out on the jackpot. Yeah, we would all feel bad in that situation. But we didn't buy the ticket!

Zeke writes:

@ Charley Hooper,

So, I see your point from the sell side. But what if you are a repeat strategic buyer? You could buy stock in target before attempting to take over target. Moreover, you could probably do more deals than optimal. Or "flirt" a bit more in order to drive up target's stock price? And what if you work for a PE fund? That strikes me as even more rife for an agency problem.

I get that there are reputational effects, but the gains from insider trading could be quite large to offset those reputation losses.

Tom West writes:

A more appropriate example would be where the original lottery ticket purchaser decides, at the last minute, not to purchase the lottery ticket and then feels cheated by missing out on the jackpot.

It's not a perfect analogy, but I did buy a ticket. There was no way of knowing that the winning numbers had been selected. That I chose to sell it to on the basis of information that I could not legally obtain would make me feel ripped off.

This may be one of those Libertarian things where the policy works for Homo Econimus, but not for human beings (sort of like taking windfall profits in a crisis - we may be better off on paper, but it doesn't matter if it makes everyone miserable).

Jeff writes:

"It is a favorite Libertarian hobby horse."

Not really. I count myself a libertarian, but not an anarchist. I'm also something of a conservative, agreeing with Edmund Burke that when you encounter a social institution whose purpose you don't immediately comprehend, you should do some investigation to find out how and why it came to be before you tear it down. Those who came before us were not all venal and/or idiots.

Charley Hooper writes:

@Tom West,

I'm confused. Why would you purchase a lottery ticket and then sell it before the winning numbers were selected?

Rick Hull writes:

Charley,

This one is easy. The ticket is "worth" X, with a payoff of Y or 0. At t=0, Tom values the expected payoff more than X. At t=1, he is hungry and sells the ticket for X in order to buy a burrito. The numbers are announced at t=2.

Rick Hull writes:

Dan,

It is possible, and even likely, to agree with your entire statement and yet still believe that insider trading prohibitions are useless at best and presumably harmful. Such prohibitions do not reduce information asymmetry and in fact increase it, particularly considering that prices themselves are the most democratic form of information. When insiders price things correctly, the overall asymmetry is reduced.

Tom West writes:

Charley, if someone offers me $5 for a $1 ticket before the draw, then I'm happy to take it and buy a ticket next week. He obviously really wanted the ticket for the lottery (maybe he really wanted to enter and was late) and I just made a guaranteed $5.

Finding out that the draw had already taken secretly place and lottery employees were buying back winning tickets and cashing them themselves? Now I'm feeling ripped off.

Again, the analogy isn't perfect, but I think it encapsulates the emotion that insider trading brings out, regardless of whether the loser "should" feel fleeced or not.

Quite frankly, if enough investors feel that they're being fleeced and that insiders are being incentivized to act against their interests, then the system is broken regardless of what should happen.

As I said, I'd like to know if there are any markets we would consider successful that freely allow insider trading. If not, the conservative within me would let some smaller, but successful markets try it first and see whether international investors flee for the doors.

Charley Hooper writes:

Tom West and Rick Hull,

You can't win the lottery unless you buy a ticket. If you decide against buying a ticket or choose to sell your ticket before the results are announced, you can't win. You had the choice. No one cheated you.

Charley Hooper writes:

Tom West,

Regarding your last point, this is from Jonathan R. Macey (Yale) in 1988:

Of particular interest in this regard is the complete lack of enforcement of the laws that are on the books in Japan and the absence of laws affecting the Hong Kong Stock Exchange. In Japan, the Tokyo Stock Exchange is roughly the same size as the New York Stock Exchange. Trading on the Tokyo Exchange is highly automated, and investors enjoy unparalleled liquidity for their shares. In recent years, corporate stock traded on the Tokyo exchange has traded at a far higher price-to-earnings ratio than corporate stock traded on the New York Stock Exchange. In other words, there is absolutely no evidence of any crisis of confidence in the Japanese capital markets despite the fact that "[t]he Japanese stock market is an insider's paradise. There is no clear rule of law prohibiting insider trading and no public record of efforts to prevent the practice."

Similarly, in Hong Kong, the regulation promulgated in 1974
to control insider trading was repealed without any discernible effects on that robust marketplace. Indeed, the recent trend towards insider trading regulation in Common Market countries appears to be due largely to pressure from the United States.

Tom West writes:

You had the choice. No one cheated you.

To me, "cheating" is predicated on presumption of the "rules" and thus will be defined differently by different people. It's why I use 'feel cheated' as opposed to 'being cheated'.

After all, I'm certain there's a whole (and historically large) class of people who would sneer at the idea that I would consider it cheating to relieve me of my lottery ticket at gunpoint. After all, what sort of idiot ignores the most basic form of human interaction? :-). If I chose to buy something and then *chose* not to protect it adequately, it's my fault.

It's all about assumptions of what constitutes fair.

Anyway, your data point about HK is interesting and an indication that markets don't instantly fall apart when insider trading is unregulated.

I looked but I couldn't find any studies indicating whether this influenced the percentage of gains that went to insiders in HK.

Still, for me, the psychology is strong. I wouldn't invest in a market where it's considered legal and ethical for insiders to take advantage of their investor's ignorance. Just as I would never knowingly do business with (or be part of) such a company.

However, I may well be in a small minority, as HK's stock market is still going strong.

john hare writes:

I can be against insider trading without advocating government involvement. If all parties involved know that it is taking place, then they can adjust their actions accordingly. Part of my resistance to the idea of insider trading is due to having heard almost identical rationalizations for insurance and welfare fraud, not to mention employees justifying 'riding the clock'.


As there is little to no likelihood of convincing those that see no problem with insider trading that it is a problem, I will just say that my company tries to avoid doing business with people that have a fluid sense of ethics.

vikingvista writes:

Some points are missed by some commentors:

1. The purpose of a stock market is not to function as a game of chance. It is to redirect capital to better uses. Uninformed buyer and uninformed seller are not lottety players, they are directors of capital. The effect of insiders is to improve the price mechanism for such direction. This benefits, rather than deters, users of capital.

2. If there is any offense against UB or US, it is in whatever human action makes them err about price. Such action comes not from the insider, but only from the companies (who have the property rights) or the government regulators (who do not). The insider cannot be an offender.

3. The insider is still making a prediction. He could be wrong about the market response, in which case he loses part of what he spent on the shares--a kind of loss never experienced by the UB or the US. The insider is still taking a risk. Not a lottery ticket type of risk, but a risk based upon specialized knowledge.

4. To whatever extent insider trading truly provides returns to the insiders, a regime in which it is permitted would offset other forms of employee compensation. So, the zero sum game argument that insider trading must come at the expense of losers, is weakened.

John hare writes:

Re the lottery analogy. It is as if ten players had winning tickets to split ten million when an insider buys another ticket knowing in advance that it is a winner. The million each for the ten become nine hundred eleven thousand each for the eleven people. The legitimate players lose eighty nine grand each.

Eliezer Yudkowsky writes:

Am I missing something, or is the underlying economic theory not extremely obvious here? Of course more insider trading leads to wider bid-ask spreads as traders expect more adverse selection against their betting. The more you expect other market participants know something you don't know and that hasn't been priced into the settled price (as it would be priced in if there were both informed sellers and informed buyers striking a market price) the greater the risk premium you should demand for agreeing to buy, or alternatively sell, after you condition on the other person being willing to sell or buy.

This seems extremely clear theoretically, and it would take pretty strong empirical evidence before I stopped believing this was how markets worked. If bid-ask spreads on modern markets don't visibly widen when the risk of insider trading grows, that could be because trading professionals are being paid to assume this risk. Then when inside trading increases, the amount the professionals get paid by retail investors to assume this risk increases, the professionals' loss to insiders increases, insider profit increases, and retail investors' profit decreases, which decreases average return on investment available to that class of investors, which decreases investment, etcetera.

Am I missing something here? To me this seems like a very obvious thought. Maybe we can't stop insider trading, but certainly insider traders make a profit and I am very skeptical that it comes from professional traders instead of retail investors. This should reduce returns on investment which reduces investment, and reduce liquidity which reduces investment, and I don't see how pricing in some of a merger premium earlier is going to increase investment in a corresponding way. Maybe the regulatory burden isn't worth it, maybe enforcement is terrible, maybe prosecution is selective, etcetera, but the underlying case for wanting to reduce insider trading does not seem at all obscure to me.

Jeff writes:

@Eliezer,

Of course it's obvious to someone who thinks like an economist. It's surprising how many economists don't. But it is right in line with the papers from a few years back that demonstrated that many economists at the AEA meetings didn't understand opportunity costs.


Don Boudreaux writes:

Regarding an exchange above between Zeke and David Henderson --

David argued (as did the pioneering scholar on this matter, Henry Manne) that proscriptions against insider trading should be left to corporations and not be hijacked or otherwise overridden by politicians or government bureaucrats or courts. Zeke then responded that such decision-making would likely have to be made at the level of shareholders, but that, practically speaking (because many large corporations have many shareholders), any efficiency-enhancing rule to proscribe insider trading would not be made because of collective-action problems among the shareholders.

David then suggested an opt-out rule: have a general prohibition on insider trading until and unless a majority (or supermajority) of shareholders votes to allow insider trading for their firm.

Two points (and forgive me if I missed if these points were made elsewhere in the comments):

First, Zeke and David presume that the best default rule is against insider trading. Why? David's rule would be desirable only if corporations generally would prefer that their insiders be prohibited from trading on inside information. It's not at all clear to me that such a presumption is justified. If collective-action problems really do plague shareholder decision-making, and if insider trading is generally in the best interests of shareholders - then David's rule would be harmful, not helpful.

Of course, if my second "if" above were different, then David's rule would be helpful, not harmful. My only point here is that we shouldn't be too quick to presume that insider trading is generally so undesirable that a default rule against it is justified.

Second, and more importantly, this discussion (including my own in the paragraphs above) overlooks another of Henry Manne's profound insights - namely, the operation of the market for corporate control.

At the risk of summarizing too bluntly Henry's nuanced explanation of the operation of that market, an active market for corporate shares - through, for example, mergers or hostile takeovers - solves the collective-action problem that would otherwise afflict owners of shares of large, publicly held corporations. Outsiders to the corporation - such as corporate raiders - specialize in monitoring the performance of corporations and mustering the financing and carrying out the activities that are necessary to assemble a controlling block of shares if and when incumbent managers are likely managing the corporation incompetently. The controlling block of shares is then used by those entrepreneurs who assembled it to oust the incumbent managers and to replace them with better managers. The corporation's new controlling owners can, and presumably will, also change whatever by-laws and policies are thought to work against the best interests of that company's shareholders.

So, if Acme Corp. 'should' prohibit its insiders from trading on nonpublic information but, for collective-action reasons (or due to the incompetency of incumbent managers), does not do so, Acme's share prices will be lower than what they would be if such a prohibition were in place. The market for corporate control will then kick in to inspire a takeover of the corporation and a change in its by-laws and policies. Acme will then start to prohibit insider trading by its executives and other agents. Likewise, of course, if Acme Corp. 'should' allow its insiders to trade on nonpublic information but doesn't currently do so.

David R. Henderson writes:

@Don Boudreaux,
First, Zeke and David presume that the best default rule is against insider trading. Why? David's rule would be desirable only if corporations generally would prefer that their insiders be prohibited from trading on inside information. It's not at all clear to me that such a presumption is justified. If collective-action problems really do plague shareholder decision-making, and if insider trading is generally in the best interests of shareholders - then David's rule would be harmful, not helpful.
I can see why you draw the conclusion, Don, that I think the best default rule is against insider trading. I don’t. So let me clarify. I, like you, buy the late Henry Manne’s argument that insider trading is good. I was simply trying to move the debate with people who share Zeke’s view off dead center. Probably I shouldn’t horse trade with the rights of others.

Don Boudreaux writes:

David:

Thanks for the clarification - but now I owe you one. I understood where you were coming from in that reply to Zeke and yet I carelessly wrote my earlier comment without signaling that I was so aware. My apologies.

By the way, I've recently re-read nearly all that Manne wrote on insider trading. It's brilliant and deep. And it shows also Henry's openness to new scholarship, new ideas, and his all-too-rare ability to admit to being mistaken.

Rick Hull writes:

Eliezer,

I doubt you will see this since it's been a few days since your comment, but I've been thinking about it and now have a response. I understand your point to be: removing prohibitions on the ability of informed traders to trade will result in, generally, wider bid/ask spreads; wider spreads are, ceteris paribus, worse than narrow.

Formulated this way, my response is easy to predict. I can accept this premise for the sake of argument and still believe the prohibitions are harmful. Ceteris is not paribus. The primary effect will be correct prices sooner. It is easy to believe that a wider spread on the correct, informed price is better than a narrower spread on an incorrect, uninformed price.

I'm sure this is sensible to you, using the market example from the end of your wonderful parable Three Worlds Collide. Isn't it better to have reality reflected by markets, even with greater volatility, than to have placid, uninformed markets which cannot guide non-market decisions? Would the home world and its inhabitants be better off without the market's synthesis of available information. Forgive me if I've misrepresented 3WC; it's been a while and I'm going from memory here.

Rick Hull writes:

Link to 2009 PDF of Three Worlds Collide. Also in web format, presumably updated, with commentary.

Well worth a read for any fan of game theory and ethical conundrums, demonstrating where logical consistency fails to provide a satisfactory resolution.

cmprostreet writes:

@Jeff,

"If total market returns are not affected by insider trades, then the profits they make have to be coming at the expense of the overall market. As an index fund holder, that's me."

This is wrong for non-obvious but provable reasons. As an index-fund holder, you earn whatever the market earns. Exactly. No more, and no less (ignoring transaction costs, which are lower for you than non-index holders anyway).

Thus,
Your return = index return = market return = total combined return of all active traders

Insider traders live entirely within the world of active traders, and thus their gains/losses cancel out with other traders within that realm (mainly day traders). As an index fund holder, it is mathematically impossible for /any/ active trader to earn at your expense, except through transaction fees, which are out of scope of what you're talking about.*

Again, this is not obvious until you look at it closely, but once you do you'll see that as a mathematical property, no active trader can gain at the expense of an index fund holder.

*I have much more detailed notes on this that I'll be able to get to after I'm done moving, but the math is irrefutable.

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