Last week, I wrote about director trading and how investors can profit from a legal form of insider trading. We explored how firms are required by law to disclose any trade made by a director. Investors can piggyback directors’ transactions and follow the ‘smart money’ — i.e. insiders who have intimate knowledge of a company’s future prospects. Disclosure rules help level the playing field between private investors and figures like Gordon Gekko, the fictional financier from Wall Street, who famously quipped, ‘If you're not inside, you're outside!’
As a general rule of thumb, a director buy is a bullish sign. Conversely, a director sell is a bearish signal. Of course, every answer sparks a new question. There are always exceptions to the rule. Readers rightly pointed out cases where a director buy was followed by a declining share price. I was reminded of the old adage: “Never cross a river that is on average 4 feet deep.”
Averages and general rules can be misleading in individual cases. What we need is a lens to look under the bonnet and gain a more nuanced understanding of the data behind the aggregates. The trick is to do this without getting bogged down in excessive detail.
This is where diversification and base rates both come in handy. Diversification, they say, is the only free lunch in investing. Base rates allow us to extract meaningful signals without drowning in detail. By diversifying across good base rate stocks, investors can navigate the treacherous waters between detail and abstraction…
The less I know, the better
In the stock market, detail can be a curse. Investors are bombarded with an overwhelming swarm of news and media hype. Without a way to filter out noise, investors risk becoming like Jorge Luis Borges’ character, Funes the Memorious, who could recall everything he had ever seen — every detail, every moment, endlessly stored without the ability to filter or forget. Funes became blinded by information, unable to generalise, abstract or function. He died a young death. What he really needed was base rates — statistics which abstract away the noise and give the signal.
In investing, base rates could refer to the probability that a particular class of stock will outperform the market. James O'Shaughnessy explains the concept in What works on Wall…
