Short-selling is when you bet against the future performance of a stock by borrowing shares to sell with the hopes of buying those shares back later at a lower price. In other words, a short sale is a bet that a company's stock will lose value. While this is a common tool of day-traders and other market professionals, what about long-term buy-and-hold investors like us? Is short-selling ever a good idea?
We asked three of our analysts whether short-selling is part of their investing arsenal. Here's what they had to say.
I never short stocks for one simple reason: the huge imbalance between the risk and potential reward.
When you buy a stock, the most you can lose is 100% of your investment. The amount you can gain is theoretically infinite. The opposite is true of selling short: Losses are theoretically infinite, while the potential gain is capped at 100%.
In addition, short-selling requires incredibly good timing. If you sell a stock short and it drops to $0, you'll make a 100% return before expenses. However, if it takes 10 years for the stock to drop to zero, you will have earned just 7.1% per year, taking substantially more risk simply to earn a pre-tax return that's lower than the long-term market average.
If investing is all about taking risks that are justified by the rewards, I just don't see short-selling stocks as a winning proposition.
I've sold stocks short before, but you have to be aware of the potential consequences. As Jordan notes, the potential downside of selling stocks short is unlimited if the stock soars. But there's also a practical aspect to short-selling that many people don't understand. For stocks that are popular among short-sellers, you can end up having to pay an additional fee that essentially compensates the shareholders who are willing to lend you shares for your short sale. In some cases, that fee can be sizable, eating into your potential gains so much that it makes selling short an unprofitable proposition. Moreover, you also have to reimburse the person you borrow shares from for any dividends that the stock pays, further adding to your costs.
My favorite way to sell short is as part of a paired trade or as a hedge against other positions. For instance, I have occasionally used short sales of bullion ETFs to protect against drops in the value of my physical bullion holdings. I've also sold shares of a less attractive company in an industry while buying shares of a stock in the same industry that I liked more. For the most part, though, I find selling short without any sort of protection to be riskier than I prefer.
I've been investing for about 20 years now, and I've never sold a stock short. I know there's money to be made in shorting, but shorting has always seemed riskier to me than holding "long" positions in stocks -- positions that you want to go up, not down.
What's my beef with shorting? When you short a stock, you're essentially rooting for the company to fail, and although you'll probably have some fellow shorters on your side, you'll have a lot more stakeholders working against you.
First, there are the company's many shareholders, who believe in the company's future success. Then there's the company's management and entire workforce working against you. Their income depends on the company's success, so they'll be doing everything in their power to keep the company competitive. Even if a company is struggling mightily, it's unlikely to go down without a fight, and you can almost never rule out a turnaround.
Finally, consider the stock market as a whole. Its long-term trend has always been up, despite its occasional crashes. When there are so many compelling companies that are likely to rise over time, I'm not that tempted to bet against any. There's more to gain by going long.