There are some things in life that are just unequivocally unbelievable, incredulously fascinating. The success of Time Warner's (NYSE:TWX) Lord of the Rings trilogy, the volatile run-up experienced by shares of the Taser (NASDAQ:TASR) entity, the preternatural beauty of the exotic Colombian bombshell Sofia Vergara... in every one of these cases, the breath is taken out of my lungs, and I am unable to think for a moment or two.
I'd like to report today on something that is equally as compelling but not necessarily as positive as the above examples; this would be more akin to the precipitous decline in the value of Krispy Kreme Doughnuts (NYSE:KKD). It's what a friend recently told me, a buddy who's about to embark on a journey through the wilds of investing.
He is seriously considering selling a stock short as his first transaction. To say my head was spinning like a top when I heard this is as much an understatement as is speculating that Seth Jayson has a slight problem with Martha Stewart these days. It threw me for a loop the size of the solar system.
Let's face it. Selling stocks short -- basically the opposite of going long stocks, whereby shares are borrowed and sold and must eventually be purchased back at a hopefully lower price for purposes of taking advantage of anticipated declines -- is a risky investing maneuver at best; at best! Remember: If you make a mistake going long stocks, you lose money. But if you make a mistake going short stocks, you essentially owe money; i.e., you will end up paying to buy shares back at a higher price to fulfill the obligation of returning the loan. Losing a known, maximal amount of money is much preferable to owing an unknown amount.
This is why I can't understand such a proposition. There are so many potential long-term candidates out there to begin one's personal career in equities. Why short anything when you can initiate positions in such blue chips as Microsoft (NASDAQ:MSFT) or PepsiCo (NYSE:PEP)? That's what you do when you're first starting out; well, that's what you do after you do one little thing before making the jump into direct ownership of individual stocks. You might want to consider owning (and dollar-cost-averaging into) the Vanguard 500 Index Fund (FUND:VFINX) as a way of setting up a well-diversified core investment.
This is the path a new investor should take. Not shorting; that road is liable to collapse in a huge sinkhole. I think part of the problem is people associate shorting with a roguish form of sophistication, a method that would be employed by a sharp, Han Solo-like businessman; it gives a certain kind of green investor the idea that he will be feared and revered by his colleagues and will be drooled over by all the ladies as though he has suddenly become the next James Bond. The truth can be more frightening, especially if one gets short-squeezed (which is a situation where a heavily shorted stock suddenly rises unexpectedly, forcing short sellers to cover as fast as Indiana Jones running away from a snake) by the likes of a killing short such as Amazon (NASDAQ:AMZN).
Shorting has its place; indeed, hedging techniques should be studied by all investors eventually, even if it is merely to pick up the skill of identifying candidates for a short squeeze. I've been investing for several years now and have yet to even come close to my first short. I plan on doing so at some point, because I want the knowledge and experience, but it won't be soon. I'm not there yet; heck, I don't even own a margin account yet, which is required for shorting. When I finally short my first stock, it will be done judiciously and risk-aversely, if that's even possible with such a scenario.
And to my short-seller-wannabe friend, I offer one word:
Don't.
Incidentally, I urge you to read the story of how the Gardner brothers shorted Donald Trump; it's one of my favorite Foolish anecdotes.
Time Warner, Krispy Kreme, and Amazon are all Motley Fool Stock Advisor recommendations. To learn more about Tom and David Gardner's newsletter, subscribe without risk for six months.
Fool contributor Steven Mallas owns none of the companies mentioned.
