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 specific advice on successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Tip of the week: “Short sellers make money fast when they win, but most wind up losing.”

When you sell short, you borrow stock from a broker and then sell it. However, you eventually have to buy back the stock on the market to return it to its owner.

If the stock falls in price while you are “short,” you can buy it back at a lower price. You have then made a profit. But if the stock rises in price, you must buy it back at a higher price than you sold it, and you lose money.

You can make money twice as fast short selling stocks than buying stocks. That’s because stocks tend to fall about twice as fast as they rise. But many “shorts” wind up losing money, because short selling stocks lacks these three key advantages of investing in stocks:

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Stock-buyer advantages

• Advantage #1: Investors can earn income from dividends.
• Advantage #2: Investors can usually hold on to their stocks indefinitely, and only sell when they wish.
• Advantage #3: Time works in an investor’s favour, since well-managed companies tend to expand over long periods.

In contrast, you face these three disadvantages when short selling stocks

• Disadvantage #1: Short-sellers don’t earn any income. Instead, they have to make good on dividends that the stock’s owner would receive. Right now, the average yield on the S&P/TSX Composite Index is 2.56%. So, on average, today’s short-sellers miss out on a 2.56% yield, and have to pay out that much to the stock’s owners, for an average disadvantage (compared to buying the stock) of 5.12% a year.
• Disadvantage #2: Short-sellers can be forced to return shares they’ve borrowed with little notice, if the owner calls it in. If your broker can’t find new stock to borrow, you can be forced to buy the stock back in the market. This may force its price up.
• Disadvantage #3: Time works against you when short selling stocks, because companies tend to grow over long periods.

Our investment advice: Above all, it’s important to remember that the odds in short selling are upside down. When you buy, your potential gain is unlimited, but all you can lose is 100%. When you sell short, your maximum gain is 100%, if the stock you short drops to zero. But a short-seller’s potential loss is unlimited, because there’s no telling how high a stock can go.

Next Wednesday, November 3, 2010, Investor Toolkit will show you how having a balanced temperament can help you avoid investment losses.

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