Market Failure

It is becoming increasingly clear there are only three ways to make money in the stock market. The first is to get lucky — which is to say turn up on the winning side of pure chance. The second is to ride a bubble — although those who ride bubbles seldom disembark in time to preserve their gains. The third is to have access to insider information.

It's that third one, recently gaining a bit more notice by the SEC, that deserves a closer look by all the rest of us. Free market ideologues like to believe that the price system provides us with all the information we need; but, when you stop to think about it, the price of a share of stock tells us very little about the true value of a company — nor about what that value might be a year, a month, a week, a day, or even a few nanoseconds in the future. Corporate executives are very adept at disguising weaknesses and exaggerating strengths. It takes time — often quite a bit of time — for truths to become public.

Market systems only can be efficient if there is a free flow of information, and a paucity of information inevitably leads to market failure. There is not now, nor has there ever been, a free flow of information — and in these days of multinational mega-corporations, the problem is worse than ever. Show me a hedge fund manager who is consistently successful and I'll show you a hedge fund manager who either embodies the unlikely fat tail of investment good fortune and soon will crash and burn, or — far more likely — receives information before the rest of us do. (By the way, the longer a "lucky streak" lasts, the less statistically likely it is that the streak is based on luck. True, unlikely things happen all the time — a very few people win two or even three big-money lotteries — but they don't do it nearly every year, year after year.)

The best investors of other people's money (with nifty personal gains when they succeed) like to claim they "study" the companies they recommend. Well, intensive study of public information might shift the odds a little bit — but the really big gains depend less on "study" than on a crib sheet. The rich and powerful, often sitting on the boards of multiple corporations while serving as executives of others, inevitably are going to "talk amongst themselves." Yes, one might call it "idle conversations about items of mutual interest," but insider trading is a much more apt description.

For those who might have wondered about my reference, above, to nanoseconds, let me explain. When a high-speed trading program, based in a supercomputer practically next door to the computers on which modern trading takes place, get information about buy and sell orders a few nanoseconds sooner than computers a few more blocks away, and minutes ahead of mere mortals, those computers are harvesting insider information. They can analyze it and act on it well before it becomes genuinely public.

The SEC has one hell of a job to do. I sincerely hope it's up to it.