Short selling stocks is a speculative, “negative sum gain”.  Profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive for investors.

Investors are often surprised when we tell them we 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 short selling 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.

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Short selling stocks when the market goes down

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.

Short selling stocks can accelerate risk

Before you sell a stock short, your broker has to be able to borrow the stock. 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.

Short selling stocks—your losses can be 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.

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 selling stocks is pure speculation

Short selling is pure speculation. It’s what a mathematician calls a “negative sum game”, since the winners have to outguess the losers by a large enough factor to pay associated costs. It doesn’t enjoy any of the advantages of conservative investing. Then too, the returns are upside down. When you buy stocks, gains are theoretically unlimited and the most you can lose is 100%. When you sell short, your maximum gain is 100% (if the stock you’ve shorted goes to zero). Again, a short seller’s potential losses are limitless.

Profitable short selling requires superhuman timing, and the inevitable mistakes can be super expensive for investors.

As a general rule, we advise against short selling much as we advise against options trading, leverage, currency speculation and bond trading. In all these activities, it’s a rare investor who makes enough profit to compensate for the risk involved.

We recommend investing in long-term blue chip stocks instead of hedge funds—or short selling

We recommend that most investors hold the bulk of their portfolios in blue chip stocks. That’s because blue chip shares offer potential for capital gains growth as well as regular dividend income.

These stocks should offer good “value”—that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above-average growth prospects in expanding markets.

Many investors associate short selling with market abuse. Do you agree? Should short selling be stopped as a practice?

Hedge funds are, in theory, a good idea, but their reputation makes them unpalatable to many investors. Where do you stand on the issue?