Why Shorting Stocks May Be a Huge Mistake
In a downward-trending market, it's easy to become frustrated with a portfolio that's drifting ever lower. That frustration often results in a desire to capitalize, somehow, on the poor market conditions. That's when some investors turn to short selling.
A person who expects a decline in asset prices can borrow shares from his or her brokerage, and then sell the shares. When, or if, the price declines, the investor buys back the shares at the lower price, then returns them to the brokerage firm.
In that particular scenario, everything worked out as planned. The investor made a profit, and the brokerage earned a commission.
However, markets and individual stocks don't always move as expected. If the price of the borrowed stock rises instead of falls, the investor is in a very different situation. In that case, the investor must buy at a higher price, meaning he or she loses money on the transaction.
That's when the true risk of short selling becomes apparent. Because a stock's price can drop no lower than zero, there is a floor on how much an investor can make on a short-sale transaction. However, in theory, a stock's price can just keep rising indefinitely. While that is a bit far-fetched in reality, there are cases where a news development or corporate acquisition sends a stock's price sharply higher overnight, catching nearly everyone by surprise.
Contrary to the scare tactics peddled by many financial gurus in the media, most stocks move higher over the long haul. That adds to the risk for individual investors attempting to profit through short-sale transactions.
"The concept of borrowing shares, selling them, buying them back at a lower price and pocketing the difference is very appealing," says Robert Davis, chief investment officer of Round Table Wealth Management in New York.
"Unfortunately, the practice falls under the proverbial 'easier said than done.' Shorting stocks in a good market environment is risky and should be avoided, as most stocks are trending higher. Shorting stocks takes a professional approach and even the most heavily shorted stocks have created losses for those taking short positions," Davis adds.
Financial advisors typically recommend against shorting stocks because of these inherent risks. Barry Goldberg, founder of Emmes Wealth Management in Syosset, New York, says investors should never attempt to sell stocks short. Instead, he advocates a diversified portfolio that captures performance of various asset classes, not all of which are highly correlated. In other words, when U.S. stocks are sputtering, other assets may be headed higher.
"Individual investors must be focused on long-term investing based on their individual goals, not trying to speculate with their hard-earned money on the direction of the market. Markets are efficient. If you know this, then let the markets work for you, versus you trying to beat the market through individual stock picking, market timing or track-record investing," he says.
"My philosophy is: Never, ever speculate with your money, especially your core investments that you need for things like retirement income, paying for rising health care costs and funding specific life goals. If you have an investment plan based on academic principles of investing and you can clearly state what you are doing and why you are doing it, then there should never be a need to speculate with your money, regardless of how much you have," Goldberg says.
Sean Burgess, founder of Burgess Financial Planning in San Francisco, holds a similar view about portfolio construction and long-term investing.
"Shorting stocks is not investing; it is speculation. I do not recommend shorting stocks with any money you would not take to a casino table. The upside is a 100 percent gain, while the downside is virtually unlimited. Most people don't understand that," he says.
Burgess adds that investors who are bearish on a stock and want to capitalize on that belief should consider buying a put option instead of shorting. "That way your downside is limited only to the size of your bet," he says.
"If you can't resist the urge to speculate, go ahead and set up a separate 'sandbox' account not to exceed more than 10 percent of total investable assets," Burgess says. "If you hit a home run, great. You can pat yourself on the back and have something to brag about at parties. If not, you won't derail your long-term financial plan."
Davis also says a separate speculative account may work for some investors, but even here, he urges caution.
"Markets cannot be predicted with certainty, so investing often requires a modest level of speculation," he says. "When investors label a particular account as 'play money' or 'speculative,' it's usually masking the fact that downside risk is not entirely appreciated. It's OK for an investor to have an account set aside for one-off investments that are riskier than their long-term strategy, but we encourage them to use sound reasoning as a decision-making basis, rather than rolling the dice."
Kate Stalter is founder of asset-management firm Better Money Decisions. You can reach her at www.bettermoneydecisions.com or on Twitter @katestalter.
