Short selling stock-or borrowing shares of stock and promising to return them to their owner at a future date-is popular these days.
After all, isn’t it clear that economic Armageddon is just around the corner? The government is printing money. Gold is at an all-time high. Major European countries are on the brink of defaulting on their debt. There is even talk of the U.S. government defaulting.
So is there money to be made by selling stocks short?
Here’s how short selling works:
- The investor borrows the shares of a particular stock.
- The investor sells the shares he borrowed and puts the proceeds of the sale in his brokerage account.
- The investor buys back the stock (hopefully at a lower price) and returns the shares borrowed to the broker or lender.
It works great if the shares of stock drop below the price on the date they were borrowed-in that case, you buy the shares at a lower price and pocket the difference. But you can get clobbered if the stock price goes up. And that’s precisely the problem.
Over time, the stock market as a whole goes up. You are swimming against the tide in your efforts to find a stock likely to decrease in price. Since all information about stocks is instantly available to millions of investors all over the world, it’s likely all stocks are fairly priced. It’s tomorrow’s news that could cause the price of a stock to drop (ask BP!). No one knows tomorrow’s news.
The data on those who attempt to pick stocks that go up (a much easier task) should discourage you from trying to find stocks that will go down. Many studies have shown that only about 5 percent of stock pickers beat their benchmark index. That’s less than you would expect from random chance.
One way to understand the risk of short selling is to look at the performance of the mutual funds that engage in this practice. These funds are managed by people who are supposed to have great expertise in picking stocks likely to tank.
According to an article in The Motley Fool, as of mid-2008, only one bear market fund had a positive return over the previous ten-year period. The average bear market fund had an annualized loss of more than 4 percent per year.
Short selling is more akin to gambling than investing. Not only is it highly speculative, but if you make a bet on it with a significant portion of your portfolio, you are also concentrating your risk. Concentration increases risk. Diversification limits it.
If you are thinking about selling stocks short, you would be wise to remember this observation by William Bernstein, author of The Intelligent Asset Allocator:
“It turns out that for all practical purposes there is no such thing as stock-picking skill. . . . It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation (particularly if you’re the lucky [mutual fund] manager).”
Short selling can be shortsighted. Don’t do it.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. . His latest book is Timeless Investment Advice.
Watch Dan on YouTube.