Massive Insider Trading Investigation Could Nail Wall Street's Biggest Names
Posted Nov 22, 2010 12:20pm EST by Henry Blodget in Investing, Banking
Related: C, GS, XLF, FAZ, JPM, BAC, MS
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The government is reportedly close to filing charges in the largest institutional insider-trading investigation in history.

According to initial reports, the investigation could ensnare Wall Street's biggest names: Goldman Sachs, SAC Capital, Wellington, Jennison, MFS Global, Maverick, Citadel, and others. (Here's a who's who of who might get nailed.)

The investigation reportedly focuses on "expert networks" -- consulting firms that pay industry participants to share insights and information with investors. Professional investors use these networks to gather information about real-time business conditions and trends in various industries (as well as, sometimes, information that could likely be characterized as "inside" information in any other context).

No matter where the investigation ends up, the government will likely present it as a huge step toward making the market "fair" for small investors.  And the same small investors will likely view it as confirmation that the "game is rigged."

Both of these conclusions will miss a far more important point.

The REAL lesson most investors should take away from the largest institutional insider-trading investigation in history is that competition in the global financial markets is so intense that it's basically idiotic to trade.

Trading is what is known as a "zero sum game." To win, you have to beat the competition. (And you have to beat the competition by more than the amount that it costs you to trade, which is extraordinarily hard to do, especially after tax).

In our experience, most investors have no appreciation for how intense their competition is. They think, "Wow--look at all this information I have.  Look at all my trading screens. Look at all my SEC filings. Look at my charts and graphs. Look at the smart fellow on TV telling me what to buy. Look at how many of my trades have made money!"

What they miss is that their competition has all this information, too -- so it doesn't give anyone an edge. They also don't understand that, in addition to all this information, the folks they are competing with have millions and millions of dollars to spend gathering information that will never be published anywhere or appear on an screen or chart or graph.

That's where the expert networks come in.  That's where contact networks in general come in.  That's where one-on-one meetings with managements and suppliers come in.

One glance from a CEO in response to a pointed question can contain more information than 500 pages of SEC filings. One nugget of scuttlebutt about the status of an important contract can make you more money than 500 hours of studying charts and graphs.  Most small investors don't understand that their competition gets this sort of information all day long.

In short, it doesn't matter whether the trading game is played on "a level playing field" (and of course it isn't.)  The New York Jets will still destroy any high-school football team, no matter what field the game is played on.

From the perspective of small investors, the game that is played every day in the global financial markets is equivalent to the New York Jets vs. a high-school football team.  And it should be no mystery which team the small investors are playing on.

So what's the smart answer for small investors in a world in which the competition is so unbelievably intense?

Don't play the trading game.

Instead, play a game you can win.

What's that game?

Long-term investing, preferably via low-cost, tax-efficient index funds.

Unlike professional investors, small investors don't have to worry about their performance in a given week or month or year.  They can avoid the second-to-second warfare that defines the professional investment business.  They can be patient and allow Ben Graham's long-term "weighing machine" to eventually do its work.

If they do that, and keep their costs low enough, they'll outperform 75% or more of the professionals.

Just as important, they won't be willingly playing a game they are almost sure to lose.