Before exploring why insider trading is wrong, investors should first note that there are actually two types of insider trading and one of those types is not nefarious. A company’s executives are often referred to as insiders. When they buy and sell shares of their company, which they must disclose, this is called "insider trading," but it is not wrong legally or ethically speaking. The other type of insider trading is wrong and here is why.
One of the principal tenants of capital markets is transparency, meaning that all investors have access to the same information. Think of capital-markets transparency this way. Chances are you would not like it if, as a shareholder of a company, the company provided only half its investors with quarterly earnings updates while keeping the numbers a secret from the other investors. Insider trading is wrong for a similar reason: Why should only a small amount of market participants be privy to information that many more could benefit from?
In some examples of insider trading, the illicit act is perpetrated by a person or parties associated with a particular company exploiting nonpublic information for their benefit. In many of these examples, it is information the company intended to make public at some point, but the important theme is this: The information is property of the company. When insider traders make public information the company has not yet approved for release, the resulting act is akin to a home burglary. Moreover, it could endanger the company and its investors.
It may sound like two young children arguing with each other, but the fact of the matter is insider trading is not fair. To start with, making money in capital markets is a difficult endeavor, one that is made even more difficult by the fact that small investors compete against large, deep-pocketed institutions. At the very least, some semblance of equality is needed to ensure orderly capital markets that encourage broad-based participation.
On a related note to the previous point, insider trading can shake the confidence of ordinary investors. Too many insider trading scandals in a condensed period of time could leave investors frustrated and wondering how they can make any money in stocks if they are consistently being put at a disadvantage by unscrupulous insiders. What insider traders, the bad type, don't realize is that the more investors are driven from the market, the more the market will suffer from liquidity issues. And that is bad for all market participants.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.