Insider Trading: How You Can Still Invest Profitably in a Dirty Market

Last Updated Nov 29, 2010 10:29 AM EST

The government is winding up a major, years-long investigation into insider trading. If the charges prove true, they'll show that the gains in some mutual funds and hedge funds have nothing to do with brilliant analysis or even luck. The big boys, illegally, got information in advance that pointed to a probable rise or fall in the price of a stock, and made their bets. The rest of us picked up the crumbs.

How many times do individual investors have to get kicked in the head this way, before changing their strategy? We need to be in stocks for long-term growth. But trying to pick individual stocks is a loser's game. Every time you buy, a professional investors sells. You're betting against the best brains, the fastest computers, and the dirtiest stock manipulations that money can buy.

Instead of fighting them, our best chance is to join them. That means buying broad-based index mutual funds, which will own some of the stocks being traded on secret information. You'll be in the game without having tried to play.

The current round of insider trading implicates not only hedge funds (the usual suspects), but two large, managed mutual funds that sell to retail investors like you and me.

The Federal Bureau of Investigation raided the offices of three mid-sized hedge funds early last week -- Level Global Investors, Diamondback Capital Management, and Loch Capital Management. Don Chu, an executive with Primary Global Research, was arrested last Wednesday and accused of passing information related to the Galleon Group insider trading case. Primary Global, a research networking firm, hires experts from various companies to advise its institutional clients. Meanwhile, the Manhattan U.S. Attorney's office subpoenaed trading and other data from two giant hedge funds -- SAC Capital Advisors and Citadel -- and two mutual fund companies, Janus Capital Group and Wellington Management. And Goldman Sachs has been questioned about the possible leakage of merger information.

None of these firms or any of their employees have been accused of wrongdoing. All of them have said that they're cooperating or made no comment. Investigations don't always lead to charges, so investors will have to wait and see.

Nevertheless, it should be clear that you and I suffer from a huge disadvantage in the stock-picking game. A junior-level executive, consulting with a hedge fund, might mention a slowdown in sales at her end of the business. The fund would put together some numbers, infer that the company will miss its earnings target, and sell short. The stock price will drop, apparently for no reason, until the facts eventually come out. The hedge fund wins. Jack and Jill investor lose.

That is, they lose if they're staking their future on a portfolio of individual stocks. Stocks can be home runs or they can be Enrons or Lehman Brothers. They can also be Microsoft -- $58 a share, if you owned it in December, 2000, but just $25 a share today. Google is a great company but who knows if it's still a great stock?

People who buy individual shares remember their winners -- every single one of them. But they forget their losers. They never average the two of them together, so they have no idea how well they've done compared with the market as a whole. They're almost certainly behind. Most professional investors don't beat their market benchmarks, over the long term. Amateurs will do even worse -- mostly because they don't sell their losers and look for better opportunities. They hang on, waiting for those losers to "come back."

No one should desert the stock market just because it's a tainted place. When you're trying to accumulate money for a comfortable future, you won't make it on bonds and bank accounts alone. You need to hold a reasonable percentage of your money in large and small U.S. and international stocks -- maybe 50 or 60 percent if you're middle aged, with the rest in bonds.

Tons of research shows that mutual-fund managers rarely (if ever) beat the broad market over the long term. So the smart choice for individuals is to buy the market itself, which you can do with index mutual funds. You'll find the widest choice of low-cost index funds at The Vanguard Group. Other fund families, such as Fidelity and T. Rowe Price, offer limited menus.

Once you've switched to an indexing strategy, insider trading can't be a risk to your personal holdings. The mix of gains and losses in your index fund will reflect any trades that the big boys make on the secret information they've paid a bundle for. Another bonus is that you'll no longer have to look for a broker or money manager to trust. "Trust" becomes moot when you invest in the market as a whole.

So let the insiders play their games. Let "flash crashes" come and go. They're not your business. Your business is to ride the stock market's long-term trends. That's the way that individuals can win.

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