It’s natural to take a moralistic
stance toward the corporate fraud and excess that have dominated business news
the last couple of years. Certainly that attitude has not been completely absent
from this book. An elementary probability puzzle and its extensions suggest,
however, that some arguments against insider trading and stock manipulation are
rather weak. Moral outrage, rather than actual harm to investors, seems to be
the primary source of many people’s revulsion toward these
practices.
Let me start with the original puzzle.
Which of the following two situations would you prefer to be in? In the first
one you’re given a fair coin to flip and are told that you will receive $1,000
if it lands heads and lose $1,000 if it lands tails. In the second you’re given
a very biased coin to flip and must decide whether to bet on heads or tails. If
it lands the way you predict you win $1,000 and, if not, you lose $1,000.
Although most people prefer to flip the fair coin, your chances of winning are
1/2in both situations, since you’re as likely to pick the biased coin’s good
side as its bad side.
Consider now a similar pair of
situations. In the first one you are told you must pick a ball at random from an
urn containing 10 green balls and 10 red balls. If you pick a green one, you win
$1,000, whereas if you pick a red one, you lose $1,000. In the second, someone
you thoroughly distrust places an indeterminate number of green and red balls in
the urn. You must decide whether to bet on green or red and then choose a ball
at random. If you choose the color you bet on, you win $1,000 and, if not, you
lose $1,000. Again, your chances of winning are 1/2in both
situations.
Finally, consider a third pair of
similar situations. In the first one you buy a stock that is being sold in a
perfectly efficient market and your earnings are $1,000 if it rises the next day
and -$1,000 if it falls. (Assume that in the short run it moves up with
probability 1/2and down with the same probability.) In the second there is
insider trading and manipulation and the stock is very likely to rise or fall
the next day as a result of these illegal actions. You must decide whether to
buy or sell the stock. If you guess correctly, your earnings are $1,000 and, if
not, -$1,000. Once again your chances of winning are 1/2 in both situations.
(They may even be slightly higher in the second situation since you might have
knowledge of the insiders’ motivations.)
In each of these pairs, the unfairness
of the second situation is only apparent. You have the same chance of winning
that you do in the first situation. I do not by any means defend insider trading
and stock manipulation, which are wrong for many other reasons, but I do suggest
that they are, in a sense, simply two among many unpredictable factors affecting
the price of a stock.
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