Perhaps it is because we are in the midst of an election year, but the scarcity of leadership among our public officials in Washington seems to be in high relief. Given my occupation, I was delighted to read recently about several members of the United States Congress, who have by their actions given new meaning to the phrase “prudent investor.” Rather, our Congressmen and women have exhibited how we should not behave as investors. Ironically, it is in this regard that Congress appears to have been uncharacteristically bipartisan.
Trading While in Possession of Inside Information
In response to a recent book, Throw Them All Out 1, by Peter Schweizer, and a related “60 Minutes” report, Congress is deliberating new legislation that will require that lawmakers adhere to the insider trading statutes of U.S. securities law. (You read that correctly. Currently, members of Congress are not subject to the same prohibitions against insider trading that apply to you and me.) Simply put, insider trading is “trading in a stock of a company while in possession of material non-public information about that company.” As a reflection of the complexity of the industry itself, securities law definitions are rarely so simple, but that is a good working definition. If you have information that the public does not have about a particular company and you trade in the company’s stock or share that information with someone who then does so, you are committing a felony offense. That is, unless you are a member of the United States Congress.
As Schweizer details in his book, former Speaker of the House Nancy Pelosi, Massachusetts Senator John Kerry and others appear to have been able, with impunity, to parlay their access to inside information into extraordinary stock market trading profits. As highlighted in a Washington Times book review by W. James Antle III (November 22, 2011), then-Madame Speaker Pelosi traded profitably in the shares of VISA while legislation related to the credit card industry was under consideration in the House. Similarly, Senator John Kerry, Schweizer reports, traded successfully in a pharmaceutical company stock while the debate on Obamacare was underway in the Senate in 2009. That Schweizer had enough data on a sufficiently broad sample of politicians who may have traded on inside information to fill a book is truly astounding.
Trading In the Absence of Inside Information
Research has shown that, for the ordinary investor, trading stocks tends to reduce long-term investment returns via increased transactions costs, inevitable timing errors, and higher taxes. I caveat this observation by acknowledging that if you have access to the research, technology and other tools available to professional traders, more power to you. The truth is that most professional money management services target the affluent and the wealthy. Most ordinary investors do not have access to this sector of the financial industry.
Are you skeptical of claims about the pitfalls of stock trading for the ordinary investor? If so, consider the results of an April 2000 Journal of Finance paper by Brad M. Barber and Terrance Odean of the Graduate School of Management, University of California, Davis.2 In the abstract to their article, Barber and Odean state the following:
“Individual investors who hold common stocks directly pay a tremendous performance penalty for the active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent…Our central message is that trading is hazardous to your wealth.”
Trading While Serving in the Role of Fiduciary
The concept of fiduciary is elemental to the investment industry. As discussed in previous issues, registered investment advisors and representatives thereof are legal fiduciaries. Fiduciaries are legally bound to act in the best interests of their clients. (Disclosure: I am a representative of an SEC registered investment advisor.) Brokers, on the other hand, earn a commission on your transactions whether your trade yields a profit or a loss. Navigating the financial markets is sufficiently challenging without having to worry whether the advice you are hearing serves your interests best. If your financial advisor is not a fiduciary, however, you have reason to interpret his or her advice with a healthy dose of skepticism, if not cynicism.
Elected members of Congress are fiduciaries of a fundamental genre. We send them to Washington to serve our best interests. One would think that this would be self-evident. Perhaps that is why U.S. insider trading laws do not explicitly prohibit insider trading by members of Congress; in other words, perhaps U.S. securities laws assume behavior among U.S. Representatives and Senators is consistent with the fiduciary standard. In light of the recent reporting on this topic, we now face mounting evidence to the contrary.
Illustrative Behavior
As we have seen, it is easy to find examples of how elected officials should not behave while in possession of inside information, and/or while serving as a fiduciary of the public. Perhaps more rare is the case in which an elected official demonstrates the negative effects of frequent trading on long-term investment returns. Rarer still is the example in which one person demonstrates all three of these elements of prudent investing. Seek, as they say, and you shall find.
The lessons associated with each of these aspects of prudent investing all came into focus recently with the news in The Washington Post about an investigation into the trading of U.S. Representative Spencer Bachus.3
U.S. Representative Bachus serves as the Chairman of the House Financial Services Committee. In his current role, he serves in a position of extraordinary trust of the public; a fiduciary of the highest order. According to journalists Scott Higham and Dan Keating, while he was the ranking Republican on that committee, Representative Bachus participated in closed-door meetings with the Secretary of the Treasury—during the financial crisis of 2008. In other words, Rep. Bachus was privy to non-public information about the government’s intervention in the financial markets. In the case of the financial crisis, this intervention involved the extraordinary step of infusing capital directly into individual financial services companies. A reasonable person might infer that Rep. Bachus has been privy to inside information; perhaps routinely. Despite all this, he traded frequently in stock options, characterizing his actions as a “hobby,” although he claims to have stopped trading upon promotion to Committee Chairman.
The Results of Trading While Serving as Fiduciary
Higham and Keating go on to highlight that during his time in Congress, Rep. Bachus’s net worth has fallen by half. In other words, Rep. Bachus has lead by example – of how to reduce one’s long-term returns if not wealth through frequent trading. (Admittedly, this loss in personal wealth could be from investment losses unrelated to his “hobby” of trading; e.g., real estate.) He has shown how one can through that trading raise suspicion of the use of insider information. As an elected official, Bachus has shown how to project the appearance of serving one’s own interest before the interests of the people. While Chairman Bachus was demonstrating the appearance of impropriety, even his own financial interests suffered.
In America, the concept of innocence until proven guilty is foundational. Rep. Bachus deserves a fair hearing. However, because of the Congressional loophole regarding insider trading, he faces no criminal charges. In fact, the Office of Congressional Ethics, investigating his trading activity is effectively toothless, with its only enforcement option being to submit the matter to the House Ethics Committee. (Leave it to the U.S. Congress to seek to strengthen a weakness in its policing process by creating an office, the sole power of which is to investigate, without the power of subpoena, and refer to the Committee whose powers were suspect in the first place.) One possible result from the on-going investigation is nothing.
Then again, at least Congress is now working on a new law to curb Congressional insider trading, known as the STOCK Act, or Stop Trading on Congressional Knowledge.4 It is about time. That the U.S. needs a law to state, as current versions of the STOCK Act reportedly does, that “members of Congress and employees of Congress are not exempt from the insider trading prohibitions arising under the securities laws” speaks to the sad state of contemporary American politics.
My hope is that the investing public can see from these examples just how difficult trading profitably can be for an ordinary investor. How many ordinary investors have the access to sensitive information of a Representative Bachus, a Senator Kerry or former Madame Speaker Pelosi? While Kerry and Pelosi appeared to have made out well on their trading, Rep. Bachus appears to have done far less well.
The begging question is, in the absence of Congressional-grade access to sensitive information, or the research, technology and experience of professional securities traders, and in the face of the results like those found by Barber and Odean, why would an ordinary investor trade—at all?
A Sprawling Yarn
History may offer an answer to this perplexing question. My wife and I recently took in a play at the New York Theatre Workshop. “An Iliad” was a remarkable rendition of Homer’s epic poem. As the play’s sole actor, Denis O’Hare, stood on the chair that served as a primary prop for the performance, he recanted from memory all the wars in which we, as the human race, have engaged throughout recorded history. We struggled to keep up, he ran through the lengthy list so quickly. It was during O’Hare’s stunning finish, guided by co-creator Lisa Peterson’s powerful interpretation of this classic text that an explanation occurred to me. Our propensity toward action—of which war is the most violent example, is among life’s limited few certainties.
A fundamental human trait is our propensity to act, regardless of whether doing so is best.
1 Throw Them All Out: How Politicians and Their Friends Get Rich Off Insider Stock Tips, Land Deals, and Cronyism That Would Send the Rest of Us to Prison, by Peter Schweizer, Houghton Mifflin Harcourt, 2011
2 “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, Vol. LV, No. 2, April 2000, p. 773-806.
3 “Rep. Spencer Bachus faces insider-trading investigation,” by Scott Higham and Dan Keating, The Washington Post, February 9, 2012.
4 “Progress in Effort to Bank Insider Trading on Capitol Hill,” Peter J. Henning, Professor at Wayne State University Law School, White Collar Watch for DealBook, New York Times, February 17, 2012.