Short-selling is the process of selling borrowed shares with the hope of buying them back at a lower price. To me, it's a sucker's bet. The odds are stacked against you. The likelihood of permanent loss of capital is greater than if you simply go long, and your potential gain is fixed. An unlevered short position has a maximum payoff ratio of just 2-to-1.

Throughout their careers, Berkshire Hathaway's (NYSE:BRK-A) (NYSE:BRK-B) Warren Buffett and Charlie Munger have typically avoided shorting stocks. If the world's best aren't doing it, odds are you shouldn't be doing it, either. I know that as an ardent disciple of Buffett and Benjamin Graham, I will most likely go through my entire investment career without having ever shorted a single share.

But if you do short, understand that in the meantime, while you are waiting for your stock to drop, a host of market participants are working to push the stock up.

The overvaluation argument
The most common reason to short a stock is that it's grossly overvalued. However, a company's management team, through some very clever tactics, can increase the per-share intrinsic value of the business without adding any tangible value whatsoever.

Value investor Mohnish Pabrai provides a brilliant illustration in his book Mosaic: Consider a company that has land worth $100 million and no other assets or liabilities. Further assume that the company's market cap is $1 billion, or 100 million shares trading at $10 a share. At that share price, the company is being valued at 10 times the intrinsic value of the land. Management then decides to issue a secondary offering of 500 million shares at $10 per share. The new balance sheet looks like this:

  • Cash: $5 billion (offering proceeds)
  • Land: $100 million
  • Total assets: $5.1 billion
  • Market cap: $6 billion

So what once appeared to be a great short candidate selling for 10 times intrinsic value -- 1,000% overvalued -- is now selling for about 17% above intrinsic value. As Pabrai eloquently put it, "The shorts just got hosed."

The inevitable short squeeze
Most market participants operate within a very emotional state of mind constantly dictated by fear and greed. When the slightest tinge of bad news surfaces, fear overcomes the markets and stock prices begin to tank. Hoping to cash in, people begin short-selling, in hopes of profiting on the way down. Once a heavily shorted stock begins to rise, short-sellers begin buying back shares to close out their positions. The heavy buying pushes the stock way up, and when it's all over, only the luckiest of short sellers will have made a profit. This silly type of investing relies more on luck than anything else for a potential profit.  

The idea that short-selling is a smart way to hedge a portfolio rarely ever makes sense, either. With thousands of publicly traded equities available today, one can construct a well-hedged portfolio composed entirely of long positions. Pabrai, who has been running his hedge fund for almost nine years now, has never shorted a stock, yet has returned more than 27% net annualized to his investors over that time. I can't think of a single short seller who has come close to that level of sustained performance.

Successful investing requires patience and discipline. Short selling forces you to watch the ticker tape each day in hopes that your timing was right. And unlike a long position, a short position that moves against you will at some point require the addition of capital to meet margin calls. Before you know it, your investing activities are being dictated by the movement in the short position, and any disciplined approach has been tossed out the window.

Loaded with risk
Remember Travelzoo (NASDAQ:TZOO) and TASER (NASDAQ:TASR) a few years back? Each time those stocks catapulted to new highs, the shorts piled in. They thought the stocks couldn't get any higher. Well, they did, and the shorts got squeezed. Ultimately, both stocks nose-dived, but only lucky timing would have yielded a short seller any profit.

One of my favorite restaurants, Chipotle (NYSE:CMG) (NYSE:CMG-B), provides another classic example. Months ago, when the stock was trading at more than $60 a share and had a price-to-earnings ratio of more than 40, Chipotle looked like an attractive short. The stock is currently trading at around $100 a share. Again, the shorts got burned.

Buffett once famously said, "Be fearful when others are greedy and greedy when others are fearful." Sage advice. Yet when you go short, you are doing the exact opposite. Why on Earth would you want to do the exact opposite of the world's greatest investor?

It's more important to know the boundaries of your circle of competence than the size of your circle. And right now, I know that making a bet where your upside is capped at 100% and your downside is unlimited is a bet where the odds are not in your favor. If the likes of Buffett and Pabrai avoid shorting, I think it's best for most everyone to do the same.

Be smart. Steer clear of the short side.

For related Foolishness:

TASER and Chipotle ("A" shares) are both Motley Fool Rule Breakers recommendations. Chipotle's "B" shares are a Motley Fool Hidden Gems recommendation. Berkshire Hathaway is a selection of both Stock Advisor and Inside Value. You can try out any of these newsletter services free for 30 days.

Fool contributor Sham Gad is the managing partner of the newly launched Gad Partners Fund, a value-centric investment partnership very similar to the original Buffett Partnerships. He has no positions in the companies mentioned. Reach him at The Fool's disclosure policy is a good bet.