No doubt about it, short selling can be extremely profitable. Then again, so can the lottery.
Recently, “The Big Short” won an Oscar for its adaptation of the best-selling book chronicling how a handful of Wall Streeters made millions betting against the housing market before the financial crisis.
“Movies like that show the extreme of winning,” says Jeff Powell, managing partner at Polaris Greystone Financial Group, a registered investment advisor in San Rafael, California. “Somebody also won the Powerball. It doesn’t make a great movie, but the average person shouldn’t be touching this in the slightest,” he says.
Shorting essentially is a strategy some use when they think an equity or debt security is going to decline in value. To short a stock, traders borrow shares from a broker and then sell them. If the stock falls in value, the trader will buy the same number of shares at the new lower price and return them to the lender, pocketing the difference.
It’s true that short selling can enhance returns, and hedge funds use the strategy to their benefit, says Albert Brenner, director of asset allocation strategy with the wealth management division of People’s United Bank in Bridgeport, Connecticut.
Because the majority of institutional investors are long only, stocks can become overvalued, and sniffing them out before they fall in value can be profitable, says Mike Sorrentino, chief strategist at Global Financial Private Capital, a Florida-based registered investment advisory.
But that doesn’t mean it’s a good idea for everyday investors. “In my mind, going short is very scary,” Sorrentino says. “The loss potential is infinite in theory.”
There are substantial risks. Investors who simply buy a stock have an unlimited upside – their profits are as much as the equity increases in value. And the loss is limited – if the company goes bankrupt, the investor will lose as much as he invested, but no more.
But shorting stocks has unlimited downside. If the investor guesses wrong when shorting a stock and the equity’s value actually increases, he will have to buy back the shares at a higher price than when they were borrowed in order to return them to the lender. And there’s no cap on how high a stock can go.
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There are also costs that aren’t there for equity buyers. An investor shorting stocks will have to pay interest on his borrowed shares. While that can start out in single-digit percentages of the money placed on the short position, that rate can increase over time if the stock becomes a popular name to short and demand for borrowed shares increases, Sorrentino says.
Additionally, shorting a stock that pays a dividend requires paying that yield to the lender.
So, in a theoretical trade involving 4 percent interest on the borrowed shares and a 2 percent dividend, a trader would have to make a 6 percent return simply to break even, Powell says.
There’s little room for error. Even the pros face headwinds associated with shorting. Powell used to run a long-short hedge fund but shut it down in favor of a long-only strategy. Most of the money the fund made came from the long side, he says.
Most retail investors don’t do well capturing all the returns of the market even if they’re long only, Powell says. And with short selling, you not only have to have the right idea, but also execute it at the right time. Shorting exacerbates any errors, he says.
For instance, people talked about real estate being overvalued years before betting against the housing market actually became profitable, Powell says.
Long-term strategies are safer. For most investors, Sorrentino advocates a buy-and-hold strategy rather than trying to time the market. Stocks are volatile, and it’s important to not sell into a panic and lock in losses if the market falters, he says.
Instead of trying to make money through shorting stocks, Powell advises investors to focus on trying to not lose money.
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In a down market, a retail investor’s best bet is to have a well-diversified portfolio, which could be balanced at 60 percent stocks and 40 percent bonds depending on an investor’s risk tolerance, Brenner says. “The advantage to being a long-only investor (is that) overall the general direction of stock prices is up.”