While reading Thicken My Wallet’s interview about stock analysts with two other bloggers, I was reminded of some of the changes in the investment industry over the last century (not that I personally witnessed them!). One of the bigger changes is the effort to ban all trading based on information advantages – to give just one example, this means that communication between company management and analysts is often meaningless because the analysts can’t be told anything that’s not obvious already. This is probably one of the reasons that analysts are all but useless in predicting short-term price moves. But aside from a change in rules helping their reputations, could all investors benefit from encouraging the use of insider information?

The situation is similar to short-selling. Many of the rules proposed to limit or ban short-selling are ridiculous – they would prop up stock prices for a bit but anyone buying those stocks would be overpaying and future returns would be reduced. Some form of up-tick rule or a similar “circuit-breaker” could help avoid targetted attacks on companies, but other than that short-sellers are important in communicating the true value of a company and they make a profit by doing so.

Insider trading is prohibited because it would allow people with an information advantage to make a profit from unsuspecting investors. While this might sound good, it also means that people without this information will continue to trade the stock based on false premises until it’s made public (just like investors in a market without short-sellers). If more insider trading and communication with analysts was allowed that would allow the information to influence the stock price sooner, communicating the changes in the value of the business.

While this may not seem like a big contribution to the market it would help many investors who don’t have time to keep up with the latest information. By making the market slightly more efficient they would be able to learn more from the stock price alone, which might actually follow the fundamentals a bit more closely. The price for this is allowing some players with better access to information to make a profit before the stock price adjusts – but there’s no mechanism that will evenly divide the change between everyone who’s holding or trading the stock. Just like short selling, it’s ok to give some profits to those who expose new information even if it’s done indirectly.

There is some risk that mangement could influence the stock price just to profit from it, but is there any doubt that they spend a lot of time doing this already? Maybe there’s some rule similar to the up-tick rule that could limit the effects of this. This seems to be the main problem with the idea. Of course sometimes all it takes to influence the price of a stock and make a profit from it is a free Yahoo account 🙂

Overall it seems that the biggest loss would be having less grounds to ridicule the efficient market theory. Anyone who invests without extensive research about individual companies – especially index investors – would benefit greatly from having another force to prevent bubbles and excessive declines. Are there any good reasons to limit people from trading a mis-priced stock just because other investors might not be in a similar position to do so?