4 Reasons I No Longer Short Markets And Securities

by: Ari and Arun

After getting 29% returns on my short financials portfolio in 2008 (with no longs!), I eventually decided to stop shorting (I shorted Greece and the big Euro banks early in 2010, losing some money, but recently those trades have done well). In late July 2011 I made a call on the S&P dropping due to Euro bank fragility and a friend sent me this image of the market's return after the call.

A Lucky Call, or Obvious in Hindsight - "S&P500 Will Drop From August On" [click to enlarge]

My call worked out but I have a few reasons for no longer shorting. It boils down to...

  1. Shorting is very different than going long: Superficially, the two are similar. You calculate the intrinsic value of an asset and then compare it to the market price. For a long, you buy the asset; for a short, you sell it. The biggest differences are time, risk/return profiles, and psychology. Also shorting is always speculation, but long investing can be speculation or investing (by the classic Graham/Buffett definition).
  2. Time is your enemy when you short: In long investing, time is your friend. When an asset's price stays low (or falls), you can keep buying it and "clip the coupons" of interest, dividends, etc. You want it to fall lower and can be patient. At an extreme, you want the price to fall below ST earnings or cash/book value per share. In contrast, when a short goes against you, your lender can crush you by forcing you out of your position or raising the collateral margin or borrow rate. Also, good news comes gradually and in a planned way but bad news comes in random and unpredictable bursts. This makes the timing of shorting very hard. If you're right on the fundamentals and wrong on timing, you lose big bucks and many nights of sleep.
  3. The risk/reward for shorts sucks: For longs, your theoretical return is infinite but your loss is capped. You can lose what you pay but get a 10x-20x return. Shorting is the opposite. At most you can make 100% (2x) if the stock goes bankrupt; but you can lose an infinite amount if the stock rises for a while and the market stays irrational longer than you can stay solvent.
  4. Personal and market psychology: As numerous bubbles in the last 20 years (Tech bubble, housing bubble, sovereign debt bubble) and last 50 years (emerging markets bubble, S&L bank bubble, commercial paper bubble, etc.) have shown, markets can be irrational for long periods of time. Mr. Market is often right but sometimes a complete doofus. So as a short speculator, you need to have flair for timing and trading, whereas this is less important (not unimportant) for long investing. (NOTE: Two books I suggest you read about bubbles: Kindelberger, "Manias, Panics, and Crashes" and Hunter and Kaufmann's "Asset Price Bubbles.")

My thesis is that most value investors have long-term mentalities and so do not have the trading prowess to be short. This is fundamental. Temperamentally, you need conviction, emotional stability, and contrarian staying power to be a good long investor. These are bad qualities for a short speculator, who needs to be nimble and trade around positions a lot. A short speculator needs a high tolerance for pain and needs to wait through pauses or the market manipulation of management.

In sum, there are brilliant short speculators out there like Andrew Lahde and Jim Chanos (see the article below). However, the number of people that can go long and short smartly over time are rare (Steinhardt and Soros were legends in doing both, and Dr. Michael Burry comes to mind, but even he prefers the asymmetric outcomes of longs). Also, by shorting you can create stress for your own investor LPs (e.g. Burry and Julian Robertson) and even have a public reputation of profiting off of misery (as George Soros, John Paulson, and others saw).

My bottom line: Know your temperament and create a method that respects it. It's very hard to be both long and short. The Tiger Cubs follow the AW Jones model of a hedged 40% net portfolio with a book of longs balancing their shorts - this is one smart way to do it. A better strategy is to be long only and then switch to bonds and cash when timing requires it.