Investments: How to Handle a Hot Tip

My broker called me the other day and, in hushed tones, whispered, "Buy this penny stock, and don't ask any questions—it could pay for your child's education!"

Holy Rukeyser, I thought, if this isn't the classic "hot tip," I'll eat my Wall Street Journal.

The conventional wisdom, of course, is to reject all tips out of hand. "Stay away from anything that needs feeding, painting, or cooking," my wise Uncle Ervin once warned me, and I suppose "cooking" could include hot tips from my broker. But the hushed urgency in his voice was enticing, and the amount he was suggesting I invest was not going to break me. I decided to take a chance.

Three weeks later I called to see how the stock was doing, more out of curiosity than concern.

"You're in luck," my broker exclaimed. "The stock has gone from fifty cents a share to four dollars!" I was ecstatic. My $2,000 was now worth over $15,000, on paper at least. It was almost equal to one year at Harvard!

Then it dawned on me. Maybe I would have to give it all back! The Securities and Exchange Commission (SEC) has strict rules against "insider trading," and if my broker really had a sure deal this time because he knew something was about to happen, then my profits might be considered illegal.

Under the Securities Exchange Act of 1934, it is against the law for a company officer, stockbroker, or investment advisor to profit from "inside information" that has not been disclosed to the public. Moreover, it is illegal for "tippees"—individuals who trade on the tips of insiders—to profit. The SEC has elaborate rules and limitations on what company officers and other "insiders" can and cannot do. For example, company presidents can purchase their own company stock, but they cannot sell it for a certain period of time.

As a financial advisor, I strongly believe that the SEC rules are counterproductive. By restraining experts from acting on their knowledge, they turn the stock market into a gambling casino rather than a source of intelligent investing.

The regulations also give license to the SEC to investigate any stock transaction that results in a substantial profit or avoids a major loss. The SEC has already investigated janitors, newsletter printers, masseuses, flight attendants, and other alleged "tippees." The agency even went after investment advisor Ray Dirks, who uncovered the Equity Funding fraud in the early 1970s. He warned his clients to sell as soon as he found out, before the press (and the SEC!) began to believe his story. Incredibly, he was indicted for illegal insider trading, although he fought back and was finally vindicated last year by the Supreme Court. His story is a prime example of the excesses of a regulatory agency.

The situation is getting worse, I'm sorry to say. Not only is the SEC prosecuting more insider-trading cases, but it supports new legislation that will triple the financial penalties for convictions. This will create massive fear among brokers, corporate officers, and investors, who will be afraid of acting on any information that has not been fully disclosed.

Will this increase public disclosure, as the SEC intends? Not at all! As one major broker stated, "It will make it more difficult to get any information from companies, who fear being accused of providing insider information."

The legal restrictions on "hot tips" and "insider trading" are all part of the "age of envy," as financial writer Gary North phrases it. The social attitude is, "If I can't have it, neither can you." The government does not want anyone to profit "unfairly" in the marketplace. Yet market information is, by its very nature, not equally available to everyone. There will always be a profit, sometimes sizeable, for those who are in the right place at the right time. It's as true for the investment analyst who discovers new information about a company and makes it known to his clients as it is for the real-estate speculator who buys an undervalued duplex. In this sense, insider trading is the lifeblood of the marketplace.

I noticed in the Value Line Investment Survey, for example, that at least a third of all changes in stock recommendations is due to "surprise" information about companies. Seasoned speculators are always on the lookout for an unexpected change in earnings, merger activity, or new issues—the dynamic characteristics of any major bull market.

European investors have always taken insider information for granted, and its use is quite legal. They are not guilt-ridden with the American anti-capitalist mentality or caught up in the "bare-all" financial world of full disclosure.

Let's go back to my own hot tip. Was this actually a case of insider trading, or was it simply a stock broker who recognized a stock that showed fundamental promise?

He said, "I simply had a hunch that another company would take over this one, and I was right." He added, "Don't worry, if the SEC calls, just tell them that I recommended the stock and you took my advice. You didn't know anything beyond that." In other words, if there was inside information involved, it was news to me. As far as I was concerned, it was just a speculative gamble on a typical penny stock. Tricky rules are like that, you know. You have to take your chances.

What should you do if you receive a "hot tip"? Should you respond immediately, as I did this time, or should you quietly hang up on the broker?

It all depends. First ask yourself, "Who is this person?" and "Why is he giving me this great deal?" You need to know the person's background, track record, and credentials. Is he a legitimate investment advisor, or is he just someone who has a great sales technique? Has he been in the business long enough to know what he's talking about? More important, ask yourself why you have been singled out to receive this "sure-fire" moneymaker. Is it because you have been dealing with him for a long time and are therefore a valued customer, or because he wants to make a commission?

Second, follow some traditional rules. Don't get greedy. Spread your risk. Don't invest too much in a single investment. The money you invest in a "hot tip" should be funds you can live without.

Mark Skousen is the author of The Complete Guide to Financial Privacy (Simon & Schuster). He and his family are living in the Bahamas.