Selling stock shorts can be fun and profitable, but it's a very risky strategy. Most stocks go up, the cost of being wrong is huge, even being right might not be profitable, and brokers charge big fees for you to short. If you're not an experienced investor who understands all the risks, then you probably shouldn't be selling short.
1. Swimming upstream
The most obvious, but perhaps most important, challenge in shorting is that, on average, stocks go up. Not every stock, and not every year, but the general trend is upwards. According to data from NYU-Stern Professor Aswath Damodaran, stocks in the S&P 500 have advanced, on average, 9% annually between 1928 and 2012. Thus, if you choose to short stocks, you're betting against the odds and history.
2. Being wrong could be your ruin
It's often pointed out that shorting offers a maximum return of 100%, with unlimited potential to lose. In practice, your potential losses aren't unlimited (your broker wouldn't allow that), but you could completely wipe out your account. In other words, if you're wrong, you could lose everything. That's a pretty big risk, considering it's very possible that you could be wrong. In investing, nobody is right all the time. Even Warren Buffett has made mistakes and lost on investments.
Here's a real-life example of how it's really easy to be wrong. Let's say you were examining a company about a year ago. The company had generated large losses for five years. Its strategy was to enter an industry dominated by a few huge incumbents, which had dominated the industry since World War II or earlier. The company was developing an entirely new, very complex product from scratch. The endeavor would require huge amounts of capital, and the company's ability to raise further capital was unknown. Finally, the size of its target market was uncertain. At best, it would cater to a large niche, and at worst, nobody would want it's products. Its founder and CEO was talented but also invested in other non-related projects. And this company had a market capitalization north of $3 billion. A reasonable analysis might have suggested that this company was a money-loser, it was on a quixotic mission, and it would never succeed. In other words, a good short candidate. That's what a lot of professional, well-informed investors thought at the time -- short interest on the company was nearly 30%.
If you hadn't already guessed, I'm talking about Tesla Motors (TSLA -1.66%), which is up more than 460% over the past year. Elon Musk and company defied the odds and met or exceeded challenging milestones, and market sentiment shifted radically. The stock went on an incredible bull run, perhaps with a few short squeezes along the way. If you had shorted the stock, you would've been destroyed. Even though your initial case against would've been completely reasonable, it didn't work out. You were wrong, along with a lot of other investors. And, since it was a short position, your losses would be catastrophic. Obviously, this is a cherry-picked example, but it illustrates the huge risks associated with shorting.
3. Being right doesn't guarantee success
Let's consider David Einhorn's battle with Allied Capital. In 2002, Einhorn publicly pointed out accounting irregularities with the company. Einhorn had a strong case and the bully pulpit. Allied Capital's stock took an initial dip after he shared his thesis. But the stock proved resilient, rising over the the next few years. Along the way, there were numerous tribulations for Einhorn. Instead of investigating Allied Capital, the SEC investigated Einhorn. Allegedly, Allied Capital stole Einhorn's phone records. His wife lost her job at Barron's. Einhorn eventually wrote an entire book on Allied Capital. By 2007, Einhorn was vindicated -- the SEC found fault with Allied Capital's business practices. Its stock fell below his short price, but the profits for his fund were small, especially relative to the time, effort, and aggravation involved.
Of course, Einhorn is a famous hedge fund manager who publicly shared his case, thus inciting a battle with the company. As an individual short-seller, you won't experience all the problems he had. But, it can still be hard. In January, I wrote a critical article about ParkerVision (PRKR). It's a small, Jacksonville, Fla.-based company that has virtually no business operations. It's been in business for 20 years without ever generating a profit. To keep itself afloat, it regularly raises equity from new investors, thus diluting existing investors. The primary beneficiaries of this non-business are its CEO, Jeffrey Parker, and his cronies in management. Even as the business loses money and shareholder value is destroyed, they keep getting paid. At present, the company's primary reason to exist, aside from lining the pockets of management, is to litigate patent claims against Qualcomm. In my opinion, the company's claims are largely hype, and its only chance to win a claim is legal incompetence (or favoritism). In August, I reiterated the case against the company, pointing out its continued cash burn. In all, there's a very solid case against this company. But that hasn't stopped the stock from running up. Year to date, the stock is up 65%. In the end, it's proof that as a short-seller you're subject to the whims of the market. Even the worst, most questionable stock might stay flat or even increase, in spite of common sense and a rational thesis.
4. The costs are very high
Short-selling is expensive. It depends on your broker and the stock, but there can be borrowing fees. If you use shorts to increase your gross investments, then you'll pay interest for using margin. Also, as a short-seller, you're responsible for paying the dividends associated with any stock you borrow. That can be expensive.
Last week, a research firm called Hedgeye suggested that investors short the shares of Kinder Morgan (KMI 1.44%) and Kinder Morgan Energy Partners (NYSE: KMP). In short, Hedgeye analyst Kevin Kaiser alleged that both companies were a "house of cards" that under-maintained their assets and manipulated their financial results. His recommendation is to actively short both companies without any specific catalyst that will cause the stocks to fall. Aside from the fact that his accusations are complete hogwash, this is a foolish suggestion. Those two companies pay respective dividends of 4.5% and 6.6%. In other words, in addition to borrowing fees, margin costs, and trading commissions, you'll need to pay 4.5% and 6.6% of your investment annually out of you account to maintain the position.
Foolish bottom line
The best way to generate returns in the stock market is to buy high quality business at a good price and hold for the long term. Shorting is challenging and risky, and most investors shouldn't do it. That's not to say it can't be profitable or useful as a hedge, but it should be done only by experienced investors who fully understand the costs and especially the risks. Even experienced investors should be selective, cautious, and careful about shorting. It's a tough way to generate returns.