Soros told me once that he lost more money selling short than on any other speculative activity. My experience is similar. The advice that comes down the pike from authors of stock market doom books - that individual investors should sell short - is a ticket to the poorhouse.
- Victor Niederhoffer, The Education of a Speculator, p. 46
The last few investment years have been difficult ones for me. When I started my business in 2006, my goal was to take advantage of a housing bubble, which I believed would implode and drag the entire economy down with it. It didn't take long for me to be proven right, and the first few years of managing money were successful ones.
Starting in 2009, however, I began to find myself on the wrong side of a runaway bull market. Fighting this bull market has been an expensive lesson for me and my clients. A review of my trading history shows that the costliest mistake has been trying to short the market. I estimate that shorting has cost us about 5% annually over the last 4 years. Missing out on the windfall profits would have been painful enough. Compounding the error by betting against the market only made things worse.
In his eclectic memoir The Education of a Speculator, Victor Niederhoffer tells the story of his grandfather Martin. Martin was wiped out during the stock market crashes in The Great Depression and the experience left deep scars. From then on, whenever stocks rose Martin was quick to short them in expectation that the next crash was just around the corner. Unfortunately for him, the 1950s was a decade more similar to the 1990s than the 1930s:
My grandfather Martin lived through a thousand financial deaths during the stock market rise as he shorted the hades out of each rally, waiting for the 1930 crashes to reemerge. (p. 45).
Later in his book, Niederhoffer explains why shorting is a loser's strategy:
The best reason for staying away from shorting stocks is the overriding 10% annual return for the past 200 years. One way of seeing this is to dig up a long term chart of the stock market averages… The overall impression is a continuous rise of some 100-fold over the past 100 years, with pauses in the 1930s and 1970s, and small downward blips in 1907, 1929 and 1987 (p. 268).
We can add the 2000s to the 1930s and 1970s as another decade of lackluster stock market performance. However, just because the stock market made no progress in those decades does not mean stock market investors lost money. They just didn't make money. Conversely, shorts didn't profit, either, unless their timing was precise. Viewed from perspective of history, secular bear markets are pauses, not declines. Previous gains are consolidated and a new base is formed from which further progress is made.
It is a cliché that we learn the most from our mistakes. The last few years have left their mark on me, but I believe an important lesson has been learned. This doesn't mean that I am turning wildly bullish 4 1/2 years into one of the greatest bull markets in history. It does mean that going forward the bar for shorting will be much higher than it has been in the past. Further, because the overall trend of history is up, the bar for shorting will also be much higher than the bar for being long. A bearish view is best expressed by being in cash, not by being short. "Any man who is a bear on the future of this country will go broke," J.P. Morgan said in 1895. Warren Buffett has been cashing checks on that proposition since 1956.