So Easy, Even a Baby Can Do It (Or How to Insider Trade Using Junior’s E-Trade Account)

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Today I’m proud to introduce you to the work of Dr. Paul Koch, an esteemed finance professor at my current school, the University of Kansas (Go Jayhawks!).

For those unfamiliar with Professor Koch’s work, he’s been a pioneer in the area of data-based examination of insider trading in various financial markets. Fascinating stuff, and I highly recommend taking the time to read and absorb his work:

http://www.business.ku.edu/paul-koch

Most recently, Prof. Koch is receiving attention for an article in the Journal of Finance that he co-authored with researchers from the University of Auckland and the University of Sydney. Harvard Law School and numerous other academic outlets are recognizing the article both for it’s clarity and it’s significant findings.

Essentially, Prof. Koch and his collaborators reviewed a very large, 15-year dataset of underage account holders in a large stock market clearinghouse entity. With typical academic understatement, the authors titled their paper “Informed Trading Through the Accounts of Children.”

In a nutshell, the data revealed a significant outperformance of the market as a whole by the accounts held in the names of children, particularly prior to market-moving events related to the stocks held in those accounts – as much as nine basis points in some instances. As the article notes:

We find that underaged accountholders exhibit superior stock-picking skills on both the buy side and the sell side over the days immediately following trades. They significantly outperform older investors by an average of 9 basis points (bp) based on all trades made one day earlier, by 7 bp based on trades two days earlier, by another 5 bp for trades three days earlier, and by an average of 2 bp per day for previous trades made over days -4 through –10.

Since this outperformance is especially evident for short horizons, it likely stems from superior private information that is about to become public. (boldface emphasis added by me). We explore this possibility, and find that underaged accountholders perform extremely well when they trade just before major information events. For example, on the day before major earnings announcements, young accountholders trade in the correct direction 57% of the time and outperform older investors by an average cumulative abnormal return on days 0 and +1 (CAR(0,+1)) of 1.1%. Likewise, one day ahead of large price changes, young accounts trade in the correct direction 58% of the time and outperform older investors by an average CAR(0,+1) of 2.1%. Finally, on the day before takeover announcements, their proportion of correct trades is 72% and their mean outperformance is a CAR(0,+1) of more than 12%.”

Quite simply, savvy insiders use their children’s accounts to insider trade and (illegally) reap the monetary rewards associated with the information disequilibrium they posses. It is common knowledge in the financial universe that most regulatory agencies can barely analyze the data on registered insiders, let alone their relatives, friends, and other associated individuals. Prof. Koch clearly proves that insider trading is easy and relatively risk-free, as long as you don’t trade under your own name.

Once again, the weasels win, and everyone else loses, and unless governments get serious about increasing scrutiny and oversight of these enormously complex financial markets, the general public can expect inferior financial returns and higher costs. As easy as taking candy from a baby indeed…

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