Saturday, October 25, 2008

Is Insider Information Useful?

In its strongest form, the Efficient Market Hypothesis (EMH) asserts that even corporate insiders cannot make money in the market. The idea is that stock prices fully reflect all information, both public and private. This idea might seem incredible, but it is believed by many in the finance industry.

However, studies by Chowdhury, Howe and Lin along with Pettit and Venkatesh (described in this paper) have demonstrated that on the aggregate, corporate insiders consistently enjoy above-average profits. This implies that stock prices do not incorporate all private info as the strong-form of EMH would have us believe.

Corporate insiders are required to report their purchases, therefore can individual investors benefit from this knowledge? For a while, some copy-cats did. But recent studies have found that this insider copy-catting no longer produces above average returns (in part because of delays in reporting and because too many investors are copying, thereby pushing prices to a point where a stock is no longer cheap/expensive).

The best way for non-insiders to make money in the markets is to understand what they buy (so they can be sure they're getting a good deal) and to apply a margin of safety!

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