The stock market is fixed. It's corrupt. The average investor doesn't stand a chance among the blood-thirsty sharks.
There are a great many people not investing in the stock market because they subscribe to exactly that sentiment above. While I may not agree with them -- like most of my fellow Fools, I believe the stock market is one of the best places for individuals to build wealth over time -- I do recognize that there are some very real, very serious threats to individual investors.
One prime threat: insider trading.
An unfair edge
In a game of Texas hold 'em poker, the most skilled player often comes out on top. Luck can and does play a role in the game, but generally the player that can calculate the odds, read the other players, and be more confoundingly inscrutable than everyone else will end up with the most chips.
This is as it should be. From an information standpoint, everyone is equal. Any given player's edge comes from an ability to play the game better and make better use of the available information.
But what if it wasn't like that? What if one player at the table sat in a special seat that allowed him to see the next card -- or the next two cards -- before they're revealed to the rest of the table. Suddenly, whether that player has any sort of skill at all, he has an informational advantage that gives him an edge over everyone else.
What do you know that I don't?
More than a decade ago, The Motley Fool played a role in advocating for Regulation Fair Disclosure (aka Reg FD). That SEC rule ended the unfair practice of corporate executives passing information to Wall Street analysts that they didn't disclose to the rest of the public. In other words, it helped create a more level playing field for all investors.
In every stock market transaction, there is a buyer and a seller. Without a level playing field for investors, every buyer has to wonder whether the seller on the other end is selling precisely because of some bit of information that that buyer doesn't -- and couldn't -- know. Sellers, meanwhile, may have to question whether the buyers they're selling to are gleefully snapping up shares because they are in possession of valuable data that few others can get access to.
In this situation, stock gains accrue to those who possess information that nobody else has, while everyone else is left at a disadvantage, unable to compete with those in the know. Just like at the rigged poker table, insider trading makes people winners not because they're smarter or work harder, but simply because they have undisclosed information.
It looks like this
As many readers may recall, in late September 2008, Warren Buffett's Berkshire Hathaway (NYS: BRK.B) announced a $5 billion investment in Goldman Sachs (NYS: GS) . The investment came right after Lehman Brothers' collapse and helped boost investors' confidence in Goldman's ability to weather the storm. The stock jumped more than 6% the day the investment was announced.
Now imagine you were somehow able to find out about Buffett's investment before everyone else. You would have ended up with a quick 6% virtually risk-free gain. Pretty sweet, right?
Hedge fund tycoon Raj Rajaratnam may have had exactly that kind of informational access. Former Goldman board member Rajat Gupta allegedly tipped Rajaratnam off to the Berkshire investment, and Rajaratnam loaded up on Goldman stock ahead of the public announcement.
But corporate insiders aren't allowed to dole out that kind of information, and Rajaratnam is now in prison for trading on heaps of non-public information.
Or consider this: In early January 2011, the U.S. Defense Department announced that the defense budget would continue to grow through 2014. This was a relief for defense contractors because there were widespread fears that the DoD would have to start cutting back spending sooner. The day of the announcement, the S&P Aerospace and Defense index was up 0.5% even as the S&P 500 fell. L-3 Communications (NYS: LLL) jumped nearly 6%, while Lockheed Martin (NYS: LMT) , Northrop Grumman (NYS: NOC) , and other major defense contractors joined in on the gains.
As with the Berkshire investment in Goldman, anybody that saw that defense budget before it was released to the general public could have made a score by buying defense stocks ahead of the announcement and cashing in on the post-release gains.
Meet 535 potential legal inside traders
What might surprise you is that while trading on tips from corporate insiders landed Raj Rajaratnam behind bars, trading on prior knowledge of a defense budget -- or proposed financial regulation, Medicare rate changes, an oil-drilling ban, or any of a host of other legislative issues -- would not be illegal for a member of the U.S. House or Senate.
Allow me to repeat: Trading stocks based on non-public knowledge of legislation and other government matters is not illegal for members of Congress.
Remember that rigged poker game above? Current laws give these lawmakers free reign to look at the next few cards in the deck and take the other side of trades -- perhaps trades that those who elected them are on the other side of -- armed with knowledge that the average Joe couldn't possibly have.
Help them clean up their act with the STOCK Act
In 2007, a bill was introduced to the House of Representatives titled "Stop Trading on Congressional Knowledge," or, simply, the STOCK Act. The bill sought to close this very obvious loophole, level the playing field, and stop affording Congress the unearned edge of trading on insider knowledge.
Roughly five years later, the bill is still gathering dust, as Congress has shown by its non-action that its members enjoy having their edge over the rest of us plebs, thank you very much.
As I noted at the beginning of this article, here at The Motley Fool, we believe very much in the power of the stock market to help people build their wealth over time. Along with that, we believe in a fair and level playing field for all investors taking part in the market.
For years now, my fellow Fool Rich Smith has been pounding the table on the STOCK Act, strongly advocating for the passage of the bill and keeping Foolish readers up to date on key developments in the fight to get it through.
Recently, the push has been gathering steam, but there's still an unsettlingly high chance that this bill ends up with Jimmy Hoffa, and members of Congress continue to be free to act on insider information.
That's why we need you.
You can join our effort quickly and easily.
- First, send a blank email to email@example.com letting us know that Congress members trading on privileged information is not OK with you. We'll keep you up to date on the progress of the STOCK Act and let you know how you can help get it passed.
- Next, add your signature to the petition urging Congress to stop the dillydallying and get the STOCK Act passed now!
At the time this article was published The Motley Fool owns shares of Berkshire Hathaway, Lockheed Martin, L-3 Communications Holdings, and Northrop Grumman. Motley Fool newsletter services have recommended buying shares of The Goldman Sachs Group, L-3 Communications Holdings, and Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.
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