Here's Why You Short Stocks

I think most investors should learn to short stocks. Why? Stocks are volatile. And, if the numbers are to be believed, there are at least as many overpriced stocks as there are underpriced stocks. Why not profit from their declines?

Two ways to track the market
The numbers to which I'm referring may be found in Motley Fool CAPS, our investor-intelligence database, which contains more than 1 million ratings for nearly 5,000 stocks.

I'll get to the details in a minute. But first, allow me an introduction. In CAPS, investors choose at least seven stocks to rate, proclaiming that they'll either beat or lag the overall market over a defined time period. Points are accrued according to how well each pick performs. Those points are then compared with a score for overall accuracy to produce a player rating ranging from less than 20 (not so good) to 100 (best in the realm).

Success in CAPS certainly does not guarantee success in managing a real portfolio. But it can be an indicator. Stock-picking prowess plays a big part in portfolio management, after all.

And as with a real portfolio, there are a variety of ways to play CAPS. You can be like Peter Lynch, filling your scorecard with stocks you know. You can specialize in an industry. You can follow Wall Street. Or you can buy what the funds are buying -- whatever stirs your Foolish soul.

More often, though, our CAPS investors either:

(a) Go long with high-quality (read: five-star) stocks, or
(b) Go short with low-quality (read: one-star) stocks.

As such, we've created two indexes that track, monthly, what we believe are the best five-star stocks and the best one-star stocks. Both are market-beaters.

Shorting for fun and profit
But between the two, the shorts are dominating, earning a rating better than 96% of the more than 60,000 who have logged into CAPS. The five-star stocks, meanwhile, are up on 74% of the broader community.

Surely some of this disparity has to do with the nature of the market lately: it's been bouncing up and down like a Super Ball on concrete. But I wouldn't be too quick to blame our itchy trigger fingers. History proves that plenty of stocks don't belong on the public markets. Shorting these issues can lend efficiency where it's too often utterly lacking.

Then there's the obvious point: For there to be a market, there must be both buyers and sellers. Short sellers, like it or not, are a part of that process.

And some of them are doing quite well. Our leaders list -- the top 10 stock-pickers, according to CAPS -- contains more than its share of bears, notably U.K.-based developer Keith Weiss, who goes by TMFKmoney in CAPS.

Of Keith's 103 picks, 95 are underperform calls -- the CAPS equivalent of a short sale. More than 80% of his calls have been market-beaters thus far. His best calls were March's shorts of those firms that would ultimately be drowned in subprime slime. Luminent Mortgage Capital (NYSE: LUM  ) and Impac Mortgage (NYSE: IMH  ) remain two of his best picks.

A word to the Foolish
Shorting can be a great way to add money to your bulging portfolio. But it also carries huge risks. Take a lesson from those who foolishly -- notice the small-f -- shorted DryShips (Nasdaq: DRYS  ) and Crocs (Nasdaq: CROX  ) . We (yes, I'm including myself here) failed to appreciate the words of caution David and Tom Gardner offered in The Motley Fool Investment Guide. Get their advice here.

And realize, too, that your greatest stock market gains will come from buying and holding great firms for very long periods of time. Even uber-bear Keith counts a bullish call on (Nasdaq: AMZN  ) as his best-ever pick in CAPS. (A 122% gain currently.)

So as the months roll on, I'll be reporting on the progress of both the five-star and the one-star indexes in these digital pages. History says that there's plenty of money to be made with each strategy.

Amazon is a Stock Advisor recommendation. Get a 30-day free pass to the service to find out how David and Tom Gardner have engineered a 37-point drubbing of the S&P 500 over the past five years. There's no obligation to subscribe.

Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Find Tim's portfolio here and his latest blog commentary here. The Motley Fool's disclosure policy is short lima beans and spinach (yuck) and long fully loaded carnitas burritos.

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