Today's topic is short-selling, i.e., betting on a stock's decline by selling borrowed shares with the expectation that one will be able to buy them back later at a lower price.

In any matter that relates to investing, it is usually worthwhile to check in with the world's most successful investor, Berkshire Hathaway (NYSE: BRK-B) CEO Warren Buffett.

Does Buffett sell stocks short?
The short answer? No. The longer answer is this:

Over the years, I've probably had 100 ideas of things to short and I would have eventually been right [on almost all of them]. But [because it's so hard to get the timing right,] I likely wouldn't have made much money and there would have been a huge opportunity cost.

No question about it: Shorting stocks is trickier than buying them, because timing is (a) much more important and (b) subject to significant uncertainty.

Would Buffett invest in a short-focused fund?
No -- but not for the reason you might think:

I would never put money with a short fund -- not because I have any problem with it ethically, but because I question if they could make money over time.

There's probably no good reason for an investor of Buffett's caliber to invest money in a short fund; however, I don't think the reason he cites is valid.

There are some investors that have demonstrated they are able to short stocks profitably on a consistent basis -- more on this later.

If Buffett doesn't believe in it, why should individual investors have any "short" exposure?
In the end, for Buffett, it's all about temperament:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

I'm certain Buffett passes his own test for stock ownership; however, most investors don't -- which is one of the fundamental reasons Buffett is so much more successful than, well, just about everybody.

Despite this, most investors should own stocks -- to varying degrees, depending on personal and external factors -- since it is the asset class that is most likely to compound your wealth over long periods of time.

How does one reconcile these two observations? What do you do if, unlike Warren Buffett, you're not gifted with the sort of temperament that allows you to contemplate a 50% stock decline with serenity?

The benefits of short-selling
One possible solution is to dedicate a small part of your portfolio to short positions, which can reduce its overall volatility ... along with the emotional toll and investment mistakes it produces.

For an illustration of this, the following table displays the 2008 returns for three model portfolios consisting of different allocations to just two funds, the SPDR S&P 500 ETF (NYSE: SPY) and the Prudent Bear Fund, a prominent fund with a short-selling focus, which gained 26.9% in 2008.

Allocation split: SPDR S&P 500 ETF vs. Prudent Bear Fund

2008 Total Return

Return Required to Get Back to Beginning of 2008 Portfolio Value

Portfolio 1: 100% / 0%

(37%)

+59%

Portfolio 2: 90% / 10%

(30%)

+44%

Portfolio 3: 80% / 20%

(24%)

+32%

Source: Author's calculations, based on data from Standard & Poor's and Prudent Bear Funds.

The advantages of lower volatility
With a portfolio with 100% exposure to the S&P 500, an investor would have borne the full effect of the brutal 2008 bear market, for a 37% loss. Meanwhile, the investor that began the year with a 20% allocation to the Prudent Bear Fund also suffered a loss, but a much smaller one. That makes a tremendous difference on two fronts:

  • The investor who suffers a 37% loss is more likely to sell at the bottom to quell the emotional pain and uncertainty associated with a massive, open-ended loss.
  • The investor who suffers a 37% loss will have a much tougher time "climbing out of the hole." A 37% loss requires a subsequent 59% gain to get "flat" -- a very tall order. Meanwhile, a gain of just 32% percent will erase a 24% loss, which is much more manageable.

Of course, if no one is able to short stocks successfully on a consistent basis -- as Buffett appears to believe -- the discussion is moot. However, I have to disagree with Buffett here: Just like in any other field, there are some folks who are good at this.

Living proof successful short-sellers exist
Take Jim Chanos of Kynikos Associates, for example, who was one of the early skeptics on Enron. His careful examination of the energy company's financials tipped him off to brewing problems that would eventually force it into bankruptcy.

Recently, Chanos told Bloomberg Television that he is short shares of large oil companies, reasoning that:

If you look at their cash-flow statements relative to their income statements, you will see companies that haven't replaced reserves in years, and haven't seen any increase in revenues in years. . . . They're borrowing their dividend. They're in effect liquidating.

Chanos did not specify which names he is short -- he did say BP (NYSE: BP) isn't one of them -- but a brief look at the reserves data for Chevron (NYSE: CVX), ConocoPhillips (NYSE: COP) and ExxonMobil (NYSE: XOM) confirms that these three companies are running hard just to stay in place.

Indeed, despite tens of billions spent on capital expenditures, only ConocoPhillips can show an increase in total proven oil reserves over the past five years -- and barely 4% annually, at that. Of course, the degree to which this "liquidation" is priced into these stocks is another matter -- they look pretty cheap at current levels.

Chanos is also short Ford Motor (NYSE: F) on the basis that it will have a hard time competing with General Motors and Chrysler Group because the latter two are heavily owned by the United Auto Workers union.

Another investor who has proven himself as a short seller is John Del Vecchio. As the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points. All told, his recommendations have beaten the market 9 out of the last 10 years -- in bull and bear markets.

Profitable investing in a bear market: The next step
In other words, it is possible to consistently earn money shorting stocks -- but the best short-sellers have theses that go beyond "it looks expensive."

If you'd like to learn how John finds excellent shorting opportunities -- and earn positive returns in a bear market and reduce the volatility of your portfolio besides, enter your email in the box below to get his free report, "5 Red Flags – How to Find the BIG Short."

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Berkshire Hathaway is a Motley Fool Inside Value recommendation. Berkshire Hathaway and Ford Motor are Stock Advisor selections. Chevron is an Income Investor recommendation. The Fool owns shares of Berkshire Hathaway and ExxonMobil. 

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