Regardless of whether you've been following the stock market for five weeks or 50 years, one thing will quickly become apparent: it's fickle.
If you invest for a long enough period of time you'll witness exceptionally long winning streaks, mind-numbingly long losing streaks, voracious bull markets, depressing recessions, and the everyday movements in between that make up the investing landscape. All the while, investors like you and I do our best to look past the day-to-day fluctuations of the market and see the bright side in the long-term outlooks of the companies and/or electronic-traded funds (ETFs) we invest in.
However, there's one long-term investment you can make that history has demonstrated will cause you to be wrong 100% of the time. Yes, I know that's a pretty bold statement since nothing in the stock market should ever be considered a guarantee. However, after proving itself time and again since 1950, the idea of short-selling the broad-based S&P 500, such as through its tracking ETF, the S&P SPDR 500 ETF, will almost assuredly put you on the wrong side of history.
Short-selling is the act of betting against a stock or ETF, such that when it goes down you make money, and when it rises you lose money. In general, stocks have just as much chance of falling as rising over the long run, so on the surface your chances of being right appear to be even with optimistic investors. However, there are a couple of major differences between the long-term buy-and-hold thesis and the long-term short-sale thesis that need to be understood, and which make short-selling a much riskier bet.
Perhaps the biggest difference is simply what you stand to gain or lose by short-selling. When you bet against a stock the most you stand to make is 100% on your investment. The lowest a stock can trade is $0, meaning your profit caps at 100%. On the flipside, a stock you're betting against can always double in value, or even move higher. Thus, your gains are capped at 100%, whereas your losses are potentially limitless. For long-term buy-and-hold investors the opposite is true: their gains are limitless and they can't lose any more money than they've invested. This is why even though the chances of stocks rising or falling are more or less 50-50, the stock market tends to romp higher over the long run, because gains to the upside are theoretically limitless.
But, there's more. Short-selling also involves the need for margin, which is a term used to describe money that's borrowed from your brokerage firm. Because short-sellers never actually own the stock(s) they're betting against, their broker will lend them money, often at a premium interest rate that currently ranges between 7% and 10% per year. This interest will slowly chip away at your profits, or even worse can compound your losses if a short-sold investment moves higher.
Statistics demonstrate this is a bad move
It's not just that short-selling a stock comes with added risks. Statistics unequivocally demonstrate that it's not a smart bet.
For example, since 1950, according to data from Standard & Poor's, the S&P 500 has had 33 corrections of 10% or more, not counting our latest correction. Stock market corrections are a relatively common occurrence in the market, and they're one of the reasons why short-sellers believe their pessimism will be warranted over the long run. But, examining the S&P 500 since 1950 and through those 33 stock market corrections yields a stunning find: the S&P 500 index eventually surpassed the high established before a correction started in all 33 instances, or 100% of the time.
Sometimes erasing the effects of a correction or bear market is done quickly. Between 1975 and 2000 there wasn't a correction in the S&P 500 that didn't take longer than two years to be completely erased. Other downdrafts, such as the Great Recession and dot-com bubble, took a little longer to be put completely in the rearview mirror. But the point being that each and every time a correction has come about, it's seemingly only a matter of time before it's completely erased.
This also goes to show that timing the market is more often than not a fruitless act. It's veritably impossible to know exactly when the stock market has topped, or bottomed for that matter, making short-selling, which is more often than not a tool that short-term traders use, a very risky investment tool.
If you really are pessimistic, consider this instead
If you're still undeterred and have a negative view of stocks as a whole, there is a potentially wiser way to bet against stocks: consider hedging with options.
We at The Motley Fool believe in the long-term investing ethos, and even if you foresee a stock market correction coming, wouldn't advise that you sell your high-quality investments because of it. Since timing the market isn't possible on a long-term basis, sticking with your investments over long periods of time will give you the best chance to compound your gains. However, this doesn't mean you can't hedge your longer-term bets with sell-side options if you're comfortable with the risk that options bring to the table and are savvy enough to consider using them.
A stock option is a contract that gives you the right, but not obligation, to purchase or sell 100 shares of stock by a specified date in the future. If you wished to bet against a stock you already own for the long-term, you could consider doing something as simple as buying put option contracts against the stock. Options come with substantially higher risk than buying or short-selling stocks (about 85% of contracts end up expiring worthless), but you won't need a copious amount of money to make an options-based hedge bet.
Often times options contracts come with a wide variance of expiration ranges, meaning in highly liquid investments, such as the S&P SPDR 500 ETF, you'll be able to place bets months or even more than two years in advance. Understand that the statistics are still against you succeeding when trading options, but if you feel strongly about a possible market decline, hedging with options could be a prudent strategy to consider.
But, if you take anything away from this, it's that betting against the stock market as a whole over the long run is not a very wise move.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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