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Challenges with Imitating Insider Transactions

Overall academic studies show that insider purchases are profitable but imitating insiders requires some work on your side. You can’t simply buy all stocks with insider purchases and expect to beat the market substantially.

Here are the challenges with imitating insider transactions:

1. Insiders are contrarian traders; they buy when the market is most pessimistic. Most retail investors don’t have the stomach to pull the trigger in those times. They would rather sell than buy.

2. Insiders increase their stake for a myriad of reasons Insiders sometimes make “public relations” buys to counter the decline in their stock prices. It isn’t always easy to distinguish between a genuine purchase and a fake one. Insiders also purchase because they think their stock is undervalued, but this doesn’t mean that they’re expecting to outperform the market. We observed thousands of profitable insider purchases in conservative stocks but they underperform the market. In fact, more than nine out of twenty insider purchases underperform the market.

3. Insiders have 48 hours to disclose their transactions. The stocks bought by insiders may appreciate significantly until they disclose their transactions. Investors wouldn’t know what to do if the stock went up 5% or 10% in that time period.

4. The market responds very quickly to insider purchases. The stocks with insider purchases go up an average of almost 1.5% within 24 hours of the disclosure of an insider purchase. You have to be in front of your computer to execute these transactions promptly; otherwise you surrender a large chunk of your return to high frequency traders.

5. There are no guarantees that insider purchases will be profitable and beat the market every year. In fact, there were long periods of time when insiders underperformed the market significantly. Between 1996 and 1998 insiders underperformed the S&P 500 index by 38 percentage points. That’s nearly 13 percentage points per year. Most investors won’t have the discipline to stick with a strategy that does this.