The Investment Scientist

Can We Front Run The Market Like Senator Burr?

Posted on: March 23, 2020

 

018443422de7644a788fd5f9daa27e3a.jpgOver the weekend, a client of mine sent me a news report about how Senator Richard Burr, head of the Senate intelligence committee, sold his stocks before the coronavirus market crash. This maneuver is called front-running the market. Simply explained, if you possess superior information that the market does not have yet, you can massively profit from this superior information by positioning your portfolio ahead of the anticipated impact the information will have on the market once it becomes public.

There is a whole body of academic studies on who has superior information. They are the usual suspects: lawmakers and company executives. Regarding company executives, research shows that CEOs and COOs have the best inside information, followed by CFOs. After that, information superiority drops off quickly. The information possessed by company directors is rarely superior. Research also shows that legislators are able to position their portfolios as they make laws. The difference between lawmakers and company executives is that the latter’s actions are heavily regulated and the former’s are not.

Folks like us who get our information from various news outlets are at the bottom of the information food chain. If even company directors hardly ever have superior information, what’s the chance that we might?. It’s actually dangerous for us to have the illusion that we have superior information because we heard it from Jim Cramer last night on CNBC. If we try to front run the market based on that, we will get slaughtered like sheep.

So what can we ordinary investors who don’t get top secret Senate intelligence reports do? First things first, do no harm by not trading on the news. We must always remind ourselves that we are at the bottom of the information food chain. Knowing our position is the first step in winning the long-term investment game.

Second, we can front-run the frontrunners. Research has shown that investors over-react to news by about a multiple of 3. In other words, if the news should send the market up 1%, the market will go up 3% because investors become overly bullish; if the news should cause the market to fall 10%, it tends to send the market down 30% since investors become overly bearish. Knowing this investor tendency, we should take money out of the market when the market is exuberant and add money to the market when it is fearful. Basically, we should follow Warren Buffet’s advice: be fearful when others are greedy, and be greedy when others are fearful. This is, however, extremely hard to carry out in real time. That’s why we need a target allocation plan and commitment to rebalancing to force us to do what’s hard to do in real time.

Just imagine, if your goal is to accumulate as many shares of stocks as possible, what’s not to like when those stocks are discounted by 35%, even 40%? In fact, the more the merrier! Don’t fret that we can’t front-run the market like Senator Burr – it’s illegal for all of us anyway – we have a solid method to build long-term wealth without clairvoyance or access to superior information.

Schedule a 2nd opinion financial review, buy my wealth management books on Amazon, or download the pdf version here.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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