Don't Let Short-Selling Tempt You

For most of us, investing hasn't been much fun lately. Few things in life are more painful than losing money. And these days, it seems that no matter what you do, whether you're a value investor or a growth investor, every investment you make continues to decline. Even businesses trading at what seem like bargain prices continue to decline: Are they values or value traps?

Frustrated by losses and a market that seems to show no immediate hope for quick gains, many investors may be tempted to try profiting from market declines by short-selling.

The skinny on shorts
Short-selling takes the stock market gospel of "buy low and sell high" and flips the two parts around. Short-sellers attempt to first sell high and then buy low. The basic transaction involves borrowing shares from your broker and selling them, with the hope of being able to buy back the shares at a lower price later on, so that you can return the shares to your broker and pocket the difference. So if you go short 1,000 shares of a company at $50 a share, you borrow the shares to sell and receive $5,000 in your brokerage account. If, a year later, the stock trades at $30, you buy back the shares in the open market for $3,000. You then return the borrowed shares to your broker, and you're left with $2,000 (less expenses), for a tidy 40% return. Not bad at all.

Our Fools don't get fooled
No doubt, many investors have made eye-popping returns in the past year or so shorting stocks. Anyone who shorted Bear Stearns (NYSE: BSC  ) , for example, near its high of $170 per share  little more than a year ago has made plenty of money. Even household blue-chip names such as Bank of America (NYSE: BAC  ) , American Express (NYSE: AXP  ) , Citigroup (NYSE: C  ) and Home Depot (NYSE: HD  ) have all fallen significantly over the past year.

Yet notice how all of these performance results are short-term in nature. The real money to be made in investing comes from taking a long-term view. An article in the Financial Times pointed out that although short-sellers can have strong performance in a given year or two, those with track records of 10 years or more trail the overall market's performance.

A sucker's bet
This outcome isn't surprising, since going short is ultimately a losing bet. With stock indexes enjoying a long-term positive return of around 10%, short-sellers start out facing a considerable headwind. On the other hand, if you focus on buying solid companies at a cheap price, you are actually taking less risk for more reward.

Think about it. If a company has an intrinsic value of $25 a share and you buy the shares for $10, you have a huge upside. But your maximum risk is just the $10 you paid for the shares. On the other hand, when you sell short, the reverse is true. Your potential losses are unlimited, since the stock price can double or triple, while the most you'll ever make is what you received from the short sale -- and that's assuming the stock goes lower.

Perhaps more importantly, the short-term nature of short-selling means that it's incredibly difficult not to keep a close eye on daily stock-price movements. Not only will doing so cause you more grief than joy with your short positions, but it could also poison your long-term investment strategy.

So before you decide shorting is for you, make sure you understand the economics of the trade: limited upside and unlimited downside. Yes, some astute investors can effectively use shorting as a portfolio hedge, but you don't want to make too many bets where your profits are fixed and your losses are unlimited. That's generally a sucker's bet.

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  • Report this Comment On August 06, 2008, at 6:37 PM, TLETTAU77 wrote:

    I think some of you at the Fool need to work on your short-sale math a bit. Let me get this straight...I short a stock and take in $5000. A year later, I buy it in the open market to cover my short at a cost of $3000. So I've made a profit of $2000. You state that is a "tidy 40% return." In another article (it was actually a piece of a Fool article that appeared in the business section of a Denver newspaper in the past week or so...), someone who writes for the Fool said the maximum gain on a short sale is 100%. I'm not a math expert, but if I have collected $5000 (effectively, my transaction proceeds) for the short sale, and covered for $3000 (my transaction cost), haven't I made a $2000 profit on my $3000 invested dollars? By my math that is a 66.6% profit, not 40%.

    Also, the max gain on a short sale is not 100%. What if I was smart enough to have shorted 1000 shares of Fannie Mae last fall at $70 (thus collecting $70,000...) and then in an even smarter move, covered the short not too long ago at $7 per share? By my math, I'd have $7,000 of my money invested but would have pocketed a gain of $63,000 on that money. Again, I'm no math expert, but I think that works out to be a bit more than a 100% return on my money (I think it's 900%, but please check my math).

    One thing you do have right is that your potential losses on a short sale are obviously shorting stocks is not for the novices out there.

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