Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you advice on the stock market and other investment topics that will help you develop a successful approach to investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “In theory, there is nothing wrong with hedge funds, but in practice it’s much more difficult to make money shorting bad stocks than it is buying good ones.”

Investors are often surprised when I tell them I see nothing inherently wrong with the basic concept of a hedge fund. In essence, hedge-fund managers are supposed to buy stocks they like, while simultaneously selling short in stocks they feel are unattractive. This aims to put their fund in a “market-neutral” position. By buying good stocks and shorting bad ones, you have hedged your stock market exposure. Theoretically, this means you make money regardless of which way the market moves.

If the market goes up, all or most of the stocks you own or have shorted are likely to gain as well. However, if you have chosen your buys and short sales wisely, and diversified, the stocks you own are likely to gain more value in total than the stocks you’ve sold short. You are unlikely to make as much profit in a rising market as a so-called “long-only” investor (one who only bought stocks but didn’t do any shorting). But you are still likely to make money.

If the market goes down, all or most of the stocks you own are likely to go down. But the stocks you’ve sold short are likely to fall more than your buys. That’s because bad stocks—those with high risk and/or little investment appeal—are particularly vulnerable to a big decline when the market as a whole is falling.

That’s the basic concept, but it’s hard to apply consistently. This is mainly due to the difficulty of making money as a short seller. Timing—getting in and out at the right moment—is vastly more important for a short seller than a stock buyer. But bad stocks tend to be more volatile and unpredictable than good stocks.

Before you sell a stock short, your broker has to be able to borrow the stock for you. The stock lender can demand the return of the stock with little notice. Failing or troubled stocks can go through stunning but temporary “rallies” or stock-price increases. When you sell a stock short and it rallies, you have to put up additional cash with the broker, so there is enough value in your account to “cover” your short—that is, buy the stock back and return it to the lender.

If the lender demands return of the stock, and your broker can’t find another lender of the stock, you have to buy it back in the market. If you and other “shorts” are bidding against each other because your borrowed stock has been “called” by its owner, the stock can soar.

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The gain is limited to 100%, the losses are virtually unlimited

It’s easy for a short-seller to be right in the long term on the low quality of a bad stock, but to lose money anyway. That can happen because the stock lender has demanded the return of the stock, or because the short seller has run out of cash, or simply because the short-seller doesn’t want to risk any further losses.

By the way, a bad stock is most likely to collapse when all the shorts have been “squeezed out of the market”. That’s because no one else would want to buy.

As a short-seller, your losses are virtually unlimited. After all, there is no limit on how high a stock can rise, regardless of its fundamentals. But the gain is limited to 100%, if the stock you’ve shorted goes to zero.

For buyers, the situation is reversed. Gains are virtually unlimited for stock buyers, since there is no limit on how high a stock can rise, regardless of its fundamentals. But the most a buyer can lose is 100%, if the stock goes to zero.

Short sellers also have to make good to the stock lender for any dividends that the stock pays while you are “short”.

When you come right down to it, there’s a large random element in stock price fluctuations. This is harder on shorts than on longs because shorts are much more at risk to losses from timing mistakes. However, many hedge-fund managers make things worse for themselves by trading too heavily, or using borrowed money, or using leverage from options, futures and other derivatives. No one can consistently time the market. When short sellers make timing mistakes, they can lose everything.

Hedge-fund enthusiasts overlook one simple fact. Short selling is an extraordinarily hard way to make money. You don’t make it any easier by hedging your shorts with some stock purchases.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

Do you have any experience short selling stocks? What first prompted you to try shorting a stock? Have you had any success with short selling? If so, have you continued to short stocks on a regular basis?