Understanding insider trading by top executives: buying and selling by top managers isn't always what it seems. True insider information is actually a very small motivator, an MIT professor finds.

AuthorJenter, Dirk C.
PositionViewpoint

Anyone following the business press over the recent months has been inundated with reports about illegal insider trading by top executives. Contrary to the media impression, most insider trading is legal and can provide rare insight into how managers are thinking about the prospects of their company. At the same time, much of the excitement about the information content of insider trades, and of insider sales in particular, turns out to be overdone.

There is an entire industry of journalists, investment newsletters and hedge funds that tries to take cues from the securities filings that top managers make when buying or selling shares in the businesses they operate. The recent rise in the U.S. stock market has once more been accompanied by an increase in stock sales by company insiders, and by the associated increase in the predictions of gloom and doom this increase allegedly implies.

So, which stock sales by top executives portend bad news? And which stock purchases signal genuine positive inside information about the firm? Answering these questions requires an understanding of what motivates executives to buy or sell shares.

To get at managers' thinking about their own firms, I've analyzed the insider trading decisions of top executives in approximately 2,500 publicly traded firms over the period from 1993 to 2001. Probably the most surprising finding is that true inside information--the kind that tends to get insiders into trouble with the SEC--plays at most a minor role in the insider trading decisions of top executives. This small role is reflected in the finding that insiders' returns, properly measured, aren't really all that much better than what an outside investor could get by following a few simple rules. (The study was published last December as Market Timing and Managerial Portfolio Decisions. It can be accessed at www.mit.edu/~djenter.)

Most insider trading decisions are motivated either by a desire to diversify executives' portfolios away from the firm, or by a general assessment of whether the firm appears undervalued or overvalued relative to its ability to generate earnings. Corporate executives, as a class, turn out to act like classical contrarian investors. They tend to be on the buy side in the stock categories that have traditionally outperformed the market: small stocks, high dividend stocks, and value stocks. They tend to sell shares in large firms, in firms with high price-earnings ratios and in firms with high...

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