Why Do Insiders Trade?

by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Friday, July 03, 2009 at 08:30 AM EDT

(Editor’s Note: This post comes to us from Juha-Pekka Kallunki of the University Of Oulu, and Henrik Nilsson and Jörgen Hellström of Umeå University.)

Many studies examine whether insiders’ trading activity is informative regarding future return on stocks. An underlying hypothesis tested in these studies is whether insider trades are driven by insiders’ superior information about the prospects of their firm and whether these trades are informative in generating abnormal returns. However, insiders may trade for reasons other than maximizing stock returns. For instance, insiders may sell their insider stocks in an attempt to better diversify their holdings and because of personal liquidity needs. In our paper, Why do insiders trade? Evidence based on unique data on Swedish insiders, which was recently accepted for publication in the Journal of Accounting and Economics, we utilize unique data on Swedish insiders to explore the various motives underlying insiders’ decisions to trade their insider stocks. In particular, we examine whether insiders’ diversification and other personal reasons have an incremental role relative to their information advantage in explaining their trading behavior.

Our data comprise detailed information on all Swedish insiders’ personal wealth including their holdings in their insider and outsider stocks and their other wealth. Moreover, the data include information on insiders’ salaries and other taxable income as well as gender. Furthermore, in our study we are able to control for several other potential factors affecting insider trading, such as the number of granted stocks and options, the number of stock acquired through the exercise of options and earnings announcements. This comprehensive data set allows a thorough investigation of the incremental role of the various motives for insider trading proposed in the literature.

We find strong support for the portfolio diversification/re-balancing hypothesis. That is, insiders with unbalanced portfolios (towards insider stock) relative to their average holdings over the sample period have a higher propensity to sell their insider stocks and they sell in larger trade sizes than insiders with less unbalanced portfolios. Regarding the behavioral biases in insiders’ trading decisions, we find that insiders tend to hold on to their losing insider stocks (the disposition effect) and that male insiders trade more frequently than female insiders (overconfidence). We also find that tax burden associated with the selling of insider stock holdings deters insiders from selling these stocks. Our results also show that insiders’ information advantage and portfolio rebalancing objectives have an interaction effect in their selling decisions. Specifically, we find that, on average, insiders avoid selling before bad news earnings announcements. However, among those insiders who actually sell before bad news earnings announcements, insiders who have allocated a greater (smaller) proportion of their wealth to insider stock sell more (less) before bad news earnings disclosures. Furthermore, our results show that insider selling is the most informative for future returns among those insiders who have allocated a relatively large proportion of their wealth to insider stock or who have the largest insider holdings. These later results suggest that insiders having the strongest economic incentives successfully time their selling to maximize their returns.

Our paper contributes to the literature on insider trading by showing that insiders do not trade solely on the basis of their superior information relative to other market participants. Insiders trade, especially sell, for many personal reasons, such as for portfolio diversification needs. They even seem to show some of the behavioral biases that have been reported to occur among regular investors.

The full paper is available for download here.

This article originally appeared on The Harvard Law School Forum on Corporate Governance and Financial Regulation.