The Smart Money Is Outsmarting You -- but You Shouldn't Care

How do you know when an investor is a little too lucky?

Sometimes it's obvious (see: Charlie Sheen's character in Wall Street), but a lot of times it isn't -- especially when you'd really like to believe that an investor is legendary, or that a particular fund enjoys its outsized track record because of an amazing team.

But the fact is that unfair advantage is alive and well, and it's remained with us well past the heady Wall Street days that brought infamy to a culture of insider trading.

Welcome to options backdatingDo you remember the scandals with options backdating?

This was back in 2006, when it came out that a lot of prominent companies had adjusted the "effective date" of options contracts given to executives. Put simply, the companies selectively went back in time to enter a date on the contracts so that they'd have maximal value to the recipient.

In October, a clever team of researchers decided to look at the 126 companies that were involved and see whether any prominent investors enjoyed "lucky" trades in those firms, both before the backdating announcement and before any surprise earnings announcements made between 2002 and 2010.

So what did they find?

As it happens, some institutional investors are rather persistently (and significantly) lucky. The raw trading gains for the "luckiest" firms, which traded in time to avoid being burned by a particular firm's backdating problems, are over 10%.

Compare that with the -7% average return experienced by the "unlucky" investors.

The interesting thing is that surprise earnings announcements carried a similar pattern: The same investors who were "lucky" with a certain firm's backdating tended to also get lucky when it came to that firm's surprise earnings announcements.

In other words, you lose... againWhat this means is that, annoying as it is to everyone else, being an institutional investor with strong executive relationships has perks. And the ability to benefit from a gentle private hint here and there is obviously one of them.

Unfortunately for those investors, the benefits to such relationships declined somewhat after the scandal, as corporates got a little leery of sharing too much private information. Unfortunately for us, we'd be naive to assume that that was the end of it.

The concept of all material information being public is a nice one, but unfortunately this evidence shows that it's simply not accurate.

The fact remains that, in investing, knowledge and new information is very, very valuable, and the investors with the most influence and the most to lose are going to go to great lengths to learn what they can as early as possible.

So what are you supposed to do?Stop worrying about trading. You're never going to beat the returns that the smart money (or should we say, the informed money) can generate when it comes to timely trades around quarterly earnings releases and scandals.

On the other hand, that doesn't mean you can't make it as a real investor.

A company with a solid, sustainable business strategy and an ability to operate in a changing world is probably going to remain that way for a while. It might not have the morbid flashiness of an Enron or the wild revolutionary streak of a Tesla, but it will have a business that can grow and last over the long haul.

Of course, opinions on whether a particular company has those qualities will necessarily vary, but these are the factors that you can analyze just as well as an institutional investor. You won't know with certainty what's going to happen next week, or even next year, but you can form an educated opinion about whether a given company can be successful or not.

With the right set of tools, a willingness to learn, and a commitment to sticking it out for a longer period, you can be just as good as the greats.

So, in the end, yes, you will essentially lose a battle every time a big investor gets some juicy information ahead of the markets. But you can still win the war -- it just won't look anything like the "winning" you saw in Wall Street.

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Anna Wroblewska has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Ford and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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