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Chapter 13. Follow the Experts > Looking at the Evidence

Looking at the Evidence

Do investors who have information that no one else has access to, that is, private information, use this information to profit? While the answer seems obvious (yes), it is very difficult to test to see whether they do because investors who trade on this information will not do so in the open. The reason for this is that the regulatory authorities, at least in the United States, specifically forbid trading in advance of significant information releases. Thus, insiders who follow the law and register their trades with the SEC are not likely to be trading on specific information in the first place. Notwithstanding this selection bias, this section begins by looking at whether insider buying and selling operate as signals of future price movements, since insiders may still have access to general in formation about the firm that outsiders do not. The second part of the section look at the more difficult question of whether those who trade illegally on private information make excess returns. While this may seem like an impossible test to run, you can at least draw inferences about this trading by looking at trading volume and price movements before major news announcements. In the final section, you will look at whether you can augment your returns by listening to equity research analysts and following their advice.

Insiders

The Securities and Exchange Commission (SEC) defines an insider to be an officer or director of the firm or a major stockholder (holding more than 5% of the outstanding stock in the firm). Insiders are barred from trading in advance of specific information on the company and are required to file with the SEC when they buy or sell stock in the company. In this section, you will begin by looking at the relationship between insider trading and subsequent stock price changes, and then consider whether non-insiders can use information on insider trading to earn excess returns themselves.


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