by Harry Browne

December 3, 1986

This seems to be the year for scandals, and Wall Street has one of its own. But our protectors at the Securities & Exchange Commission (SEC) will keep us safe from harm.

Being against insider trading is like being against sin or being for apple pie. No decent, God-fearing person wants to see insiders take advantage of honest investors.

Unfortunately, apple isn't one of my favorite pies, and I'm not even sure I'm against sin. So I'm having trouble getting myself worked up about insider trading.

The current pronouncements are consistent with the great American philosophy: "If you don't get what you want, sue somebody." Whatever happens, don't take responsibility for your own life. Investors shouldn't have to think for themselves, and they shouldn't have to feel responsible for their investment losses. There are bad men out there who took advantage of them.

The insider scandals have raised again the concept of the "level playing field." We're all supposed to compete on the level playing field of life — in which, I suppose, no one has the advantage of being able to run downhill. I guess this means that all financiers will have to go to the same school of business, and all doctors will have to go to the same medical school — to avoid giving anyone an unfair advantage over his competitor.

There are so many mistaken assumptions and fallacies in the current insider witch hunt that it's hard to know where to start.

Zero Sum Games

In the first place, investors are not necessarily competing with one another. The investment markets are not "zero sum games" in which one player's gain is offset by a loss to someone else. If they were, they would have faded out of existence years ago — replaced by casinos that offered free drinks as you gamble.

When two people exchange money and stock, the transaction is not much different from two people exchanging money and doughnuts — a mutually profitable exchange. No economist in his right mind would call the two people "competitors" or attempt to identify which is the "winner" and which the "loser. "

If a man buys a stock at $30 and sells it at $42 to another man who later sells it at $51, which is the winner and which is the loser?

The answer is self-evident. Each is a winner, and each unintentionally helps the other as he pursues his own goals. It's just like any other free market transaction.

What if one of those two investors had "inside" information? By competing on a tilted playing field, did he hurt the other investor?

Let's suppose Mr. Outsider bought the stock at $30 and then decided on June 1 to sell — and did so at $42. Mr. Insider obtained some very special information on June 1 about something that would occur on June 10. So he bought at $42 from Mr. Outsider. On June 10 the expected event occurred on schedule, the price jumped to $51, and Mr. Insider sold and took his profit.

The fairness buff sees this example and concludes that Mr. Insider made his profit at the expense of Mr. Outsider. But that assumes, even if it's not recognized, that Mr. Outsider sold only because Mr. Insider wanted to buy.

In fact, Mr. Outsider sold for his own reasons. If he hadn't sold to Mr. Insider, he would have sold to someone else. And if Mr. Insider's presence in the market had any effect upon Mr. Outsider, it must be that Mr. Outsider received a higher price for his stock than if Mr. Insider hadn't been bidding for it.

No, says the fairness buff, you don't understand; Mr. Insider should have made his information public before he bought the stock.

But if Mr. Insider had to make public his information, he wouldn't buy the stock at all — since the price would already have risen by the time he could buy. And if he can't buy the stock without revealing the information, he probably won't bother to do either. So Mr. Outsider still would have sold his stock at $42.

Mr. Insider didn't cost Mr. Outsider anything. So how would a level playing field make Mr. Outsider any better off? (Even if Mr. Outsider sells at a loss, the principle is the same. He would have had the same loss if Mr. Insider had stayed out of the market.)

Wait a minute — we're forgetting someone. What about Mr. Latecomer — the poor guy who bought Mr. Insider's stock at $51, at the very top?

Mr. Insider didn't make the stock rise to $51; he didn't create the event that caused the price rise; he only profited from it. The stock would have gone up in any case — and Mr. Latecomer would have lost in any case.

The essence of the insider-trading argument is the idea that no one should have access to help that you and I don't have. But everyone's situation is different. Some people have better computers, subscribe to more newsletters, get phone calls in the middle of the night warning them of market crashes, have a better feel for the market, get better executions from their brokers, receive free advice from their brothers-in-law, and in many other ways enjoy unfair advantages. Where do we draw the line'?

Heard in the Alley

The Foster Winans case was a landmark in government efforts to protect the public.

Mr. Winans wrote the "Heard on the Street" column for The Wall Street Journal. The column reported good or bad opinions about individual stocks — opinions coming from "savvy" Wall Street traders.

He had a roommate who knew in advance what the column would say. The roommate and a broker conspired, with Mr. Winans' knowledge, to buy ahead of time the stocks that were to be touted in the articles. As such, they supposedly made profits on this inside information.

If their profits came at any investors' expense, it would have to be those who bought a stock after an article appeared — because the roommate's advance purchase would have made the stock slightly more expensive than it would have been otherwise.

But so what?

A basic investment rule is never to buy an investment because of the publication of good news. It will be a tough job to protect investors who think they can get rich by buying stocks touted in The Wall Street Journal — because those people need a lot more protection than just the elimination of insider trading.

Employers & Employees

Since The Wall Street Journal is a respectable newspaper, it's not likely to look kindly on employees who get involved in such schemes. For one reason, it wouldn't want the columnist choosing stocks for his columns according to how well they suit his private scam.

And so one would expect The Journal to have rules about such things — as in fact it does. If it didn't, Investor's Business Daily could gain an edge by providing a similar column with more useful information.

The situation is similar for law firms, accounting firms, investment banks, and other companies whose employees might be aware of sensitive information. It's bad for business to become known as a company that can't keep a secret. (Look at the CIA.)

So most of these companies require employees to sign secrecy agreements. They are even in a position to sue former employees who have violated their oaths.

And that's the real point. The injured party isn't an investor rolling down a tilted playing field. The "victim" is the company whose employee has violated his contract.

In the Ivan Boesky case, the culprit is the individual who sold Mr. Boesky information that the culprit had promised not to reveal. And the victim is the company that person worked for. As such. it is properly a civil matter, not a criminal

So why do we need SEC storm troopers to regulate what insiders do?

Victims?

The crusaders are always on the lookout for a new class of victims — for whose protection new legislation will be urgently needed. Victims have already included Negroes, women, homosexuals, tenants, borrowers, employees, and so on.

The newest victim is the investor who is being denied his rights under the 37th Amendment, to wit: "No investment exchange, dealer, or broker shall deny a level playing field to any investor."

After all, a lone investor is helpless. How can one person by himself hope to compete with the Ivan Boeskys of this world?

Actually, that's one reason we have mutual funds pension funds, commodity pools, limited partnerships, money managers, financial broadcasting, and (dare I say it?) investment newsletters. All these things enable an investor to have professional help.

If someone loses money continually in the investment markets, it isn't because there are insiders, arbitrageurs, market-making specialists, floor traders, scalpers, raiders, or other bogeymen. He loses money because he isn't a competent investor. No matter what laws are passed, he'll continue to lose money until he learns to be a better investor or he delegates the job to someone more competent.

Insider Losses

One way the witch hunters attempt to rally the public is to call attention to the obscene profits of the witch who's being hunted. It's assumed that inside information is a license to print money.

Unfortunately, the SEC doesn't compile statistics showing the number of times that "inside information" didn't pay off. They have too much to do making pitches for an enlarged staff of prosecutors.

Although we'll never know, I suspect that more money has been lost with inside information than gained. Many times in my investment career, someone has told me about information that came from a special source — none of which ever proved to be worth anything.

My favorite example was the head of the precious metals department at a "Big 3" Swiss bank, who guaranteed to a friend of mine in 1970 that gold would never go above $40. Asked how he could be so sure, he said, "Because we control the market."

There are newsletters devoted solely to tracking the (legal) transactions of company officials dealing in the stocks of their own companies. If insiders know something we ought to know, those newsletters ought to be racking up outrageous profits for their subscribers. But somehow they seem to be in the same slow-pitch league where we mere mortals play.

Pandora's Box

The grandstanders on Capitol Hill will do their best to capitalize on the insider trading excitement. It may not be IranGate, but you do the best you can with what you have. Appropriate legislation will be passed to make the playing field more level as defined by Senator Kennedy or Senator Cranston.

Even if you find my arguments about insider trading empty, I hope you aren't foolish enough to think the government is going to solve the problem for you. The government can't enforce your wishes without the wishes of millions of other people being added to the package. If you get what you want, you'll also get a lot of things you hadn't bargained for.

The net result will be less efficient markets, higher costs in trading and investing, wider bid-ask spreads, higher costs for legal insurance, and the suppression of information that's available now. But none of these costs will come with a tag attached saying, "Necessary because of insider trading prosecutions.

I don't bother raising arguments in this newsletter unless I think those arguments are being overlooked elsewhere.

And, although I haven't seen much sense written on this subject so far, I probably wouldn't have raised it if it hadn't been for one thing.

On November 24, the Financial News Network (a television network that provides market news all day) reported that attorneys had filed a number of class-action suits on behalf of investors against the infamous insiders. The reporter named the stocks involved, and invited viewers who had bought the stocks between certain dates to participate in the suits. The network even displayed the names of the attorneys and their telephone numbers on the screen. And so the journalists and the ambulance chasers are joined.

I have to remind myself occasionally that financial journalists are merely journalists specializing in finance. As such, they're no more aware of what makes the world go 'round than other journalists are — and so they're not able to comprehend the nature of a free-market transaction between consenting adults.