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Nate Silver's popular book on the art and science of prediction, The Signal and the Noise has a chapter on financial markets called If you can't beat em.... The chapter spends some time discussing the statistics of market movements and the implications of the Efficient Market Hypothesis (EMH) on investment performance and its usefulness in predicting future investment performance.

Silver is not pointing out anything new when he argues that the short runs of past success investment managers use to persuade us they have skill are actually useless in predicting their future performance. It is almost a definition of the EMH that analysis of past trends and public information cannot be used to beat the market (more subtle versions admit some possibility to beat the market but not by large enough amounts to profit after transaction costs). See this related question on investment skill: Do investment managers pick stock portfolios better, on average, than monkeys throwing darts?

But, of course, some people have inside information not known to the public, though most markets prohibit profiting from such insider knowledge. In discussing the possibility of insider trading Silver makes the following assertion (p342 in my hardback edition):

One disturbing example is that members of Congress, who often gain access to inside information about a company as they are lobbied and who also have some ability to influence the fate of companies through legislation, return a profit on their investments that beats market averages by 5 to 10 percent per year, a remarkable rate that would make even Bernie Madoff blush.

So, is Silver right? Is there strong evidence that members of Congress make excess trading profits that look like exploitation of insider knowledge?

Note: the key issue is not whether some profits are made some of the time. The statistics of markets can generate large profits over several years for participants that are merely statistical runs of luck and not evidence of either skill or insider knowledge. Evidence for skill or inside knowledge requires strong statistical evidence that profits are higher than the market return over an extended period of time.

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matt_black
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    Is the claim that the average returns of all members of Congress, put together, solidly beat the markets? That's a much stronger (and more disturbing) claim than the title. The title's claim, that *some* US senators make abnormally high returns, is likely to be true just based on random fluctuations, but a similar number would be expected to make abnormally low returns too. – Oddthinking Jul 14 '13 at 17:12
  • @Oddthinking Even assuming there's nothing foul going on it wouldn't be that strange for the wealthy elite that are connected to some of smartest people on the planet to beat the market. – Kit Sunde Jul 14 '13 at 17:32
  • @Oddthinking Good point. I think, though, that Silver's claim is that *some* congressmen and senators show persistent abnormal returns over time that can't be explained by survivor bias. I guess this implies evidence of excess returns over an extended time for individuals. – matt_black Jul 14 '13 at 17:34
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    @KitSunde Except that the statistical evidence on, for example, Wall Street fund managers, suggests they **don't** *consistently* beat the market despite being a well connected wealthy elite. – matt_black Jul 14 '13 at 17:36
  • @matt_black Where have you read that? – Kit Sunde Jul 14 '13 at 18:12
  • @KitSunde Burton Malkiel's *A Random Walk Through Wall Street* for a start and in most other books and research on the EMH. – matt_black Jul 14 '13 at 18:21
  • @matt_black Nate Silver doesn't claim that "*there [is] strong evidence that members of Congress make excess trading profits that look like exploitation of insider knowledge*". He claims that "*members of congress [...] return a profit on their investments that beats market averages by 5 to 10 percent per year*". –  Jul 14 '13 at 18:35
  • @Sancho I haven’t read the book but to me as an outsider it *does* sound like he’s claiming exactly that. Otherwise, why mention the fact at all? Only the interpretation makes it in the least interesting. I think you may be failing to pick up Silver’s implicit allegation. – Konrad Rudolph Jul 14 '13 at 18:39
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    @KonradRudolph People mention things to skew impressions. He can make a safe, defensible claim while injecting irrelevant information to skew the reader's impression. I *am* failing to pick up on implicit allegations, intentionally. We should address actual claims. –  Jul 14 '13 at 18:41
  • @Sancho I'm not particularly concerned with the idea that politicians engage in insider dealing but only with the fact of excess returns; others can judge the mechanism. However, the paragraph I quoted is from a section whose *subject* is insider trading. And the sentence immediately preceding the quote is: "There is fairly unambiguous evidence...that insiders make above average returns." Judge for yourselves what implication is intended. – matt_black Jul 14 '13 at 19:06
  • @Sancho Even if implicit, it *is* an actual claim. And the implicit claim “there is good evidence that US senators are implicated in insider trading” would be a good fit for this site. And going from Matt’s last comment it seems the claim isn’t even that implicit after all. – Konrad Rudolph Jul 14 '13 at 19:11
  • @KonradRudolph Sorry, when I said "actual" I meant to say "explicit". –  Jul 14 '13 at 19:24
  • @KonradRudolph Who judges what the implicit claim is? It is just left to the community on a case-by-case manner? Or do we defer to the asker? What if an asker sees an implicit claim that many others don't see? –  Jul 14 '13 at 19:26
  • @Sancho Well in this case the asker has made it clear that this is *not* the claim he’s examining. In general it’s *always* the job of the community to interpret a claim – sometimes it will be more obvious and sometimes less. – Konrad Rudolph Jul 14 '13 at 19:30
  • Slightly related: [Is Congressional net worth up nearly 3700% since 2004?](http://skeptics.stackexchange.com/questions/5441/is-congressional-net-worth-up-nearly-3700-since-2004) – Henry Jul 15 '13 at 05:39
  • @Henry not related, unless it applies only to those members who were already there pre-2004. If others are taken into consideration, could just mean that those entering congress in 2004 were wealthier than their replacements by quite a bit. – jwenting Jul 15 '13 at 05:47
  • @jwenting: I thought people might be interested in other claims that members of Congress made abnormally high returns – Henry Jul 15 '13 at 05:52
  • @Henry they might be, but simply claiming they as a group got wealthier means nothing if changes in the makeup of the group aren't considered. – jwenting Jul 15 '13 at 05:54
  • @matt_black - you DO realize that most Wall Stree fund managers aren't at liberty to make any random trades they want or have any random holdings they want, right? Or that they are supposed to reduce risk (thus reducing returns). or that they operate on large scale and simply can't invest in more-return-friendly stuff like super small cap stuff. – user5341 Jul 23 '13 at 16:39
  • Not related to a sitting (but a future) senator: http://en.wikipedia.org/wiki/Hillary_Rodham_cattle_futures_controversy – user5341 Jul 23 '13 at 16:40
  • @DVK Indeed, but the evidence suggesting almost no traders exhibit skill are based on risk-adjusted returns. – matt_black Jul 23 '13 at 20:43
  • @matt_black - and accounting for fund style, mandate, compliance, and size of available investments? – user5341 Jul 24 '13 at 00:18

1 Answers1

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Pre-2004, there was "no academic literature dealing with Congressional stock returns" (Ziobrowski 2004).

The only related literature is Boller (1995), who investigated a random sample of Congressional delegates (both Senators and Members of the U.S. House of Representatives) and found that 25% of them invested in companies that could be directly affected by ongoing legislative activity. However, this result merely suggests a potential conflict of interest. (Ziobrowski 2004)

From (Ziobrowski 2004):

We document that a portfolio that mimics the purchases of U.S. Senators beats the market by 85 basis points per month, while a portfolio that mimics the sales of Senators lags the market by 12 basis points per month.

Also from (Ziobrowski 2004):

After acquisition, the cumulative abnormal return rises over 25% within one calendar year after the purchase date. The cumulative abnormal returns for the portfolio of stocks sold by the Senators are near zero for the calendar year after the date of sale. However, these same stocks saw a cumulative abnormal positive return of 25% during the year immediately preceding the event date. These results suggest that Senators knew appropriate times to both buy and sell their common stocks.

Ziobrowski applied this same methodology to members of the US House of Representatives with similar results (Ziobrowski 2011):

A portfolio that mimics the purchases of House Members beats the market by 55 basis points per month (approximately 6% annually).

(Bainbridge 2010) cited (Ziobrowski 2004), saying:

“trading with an informational advantage is common among Senators.”

(Bainbridge 2010) calls it a "reasonable inference" that some senators "were using material nonpublic information about companies in whose stock they trade", but doesn't claim that it has been proven.

References

Bainbridge, Stephen M., Insider Trading Inside the Beltway (June 30, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-08. Available at SSRN: http://ssrn.com/abstract=1633123

Alan J. Ziobrowski, Ping Cheng, James W. Boyd and Brigitte J. Ziobrowski (2004). Abnormal Returns from the Common Stock Investments of the U.S. Senate. Journal of Financial and Quantitative Analysis, 39, pp 661-676. http://dx.doi.org/10.1017/S0022109000003161.

Ziobrowski, A., Boyd, J., Cheng, P., et al. (2011). Abnormal Returns From the Common Stock Investments of Members of the U.S. House of Representatives. Business and Politics, 13(1), pp. -. Retrieved 14 Jul. 2013, from doi:10.2202/1469-3569.1308