The Advantages of Short Selling

It always amazes me that so many active investors who pick individual stocks, rather than buy funds or get passive market exposure through index funds and ETF's, are unwilling to express their bearish views through short selling. Instead, they sell outright, or buy puts, or hedge with some other passive device to lower their market exposure.

If you have the guts to buy a stock, presumably you've decided that the stock is at least relatively cheaper than its competitors, or stocks in general. Whatever the insight to that decision should be "reverse engineered" allowing stocks to be identified as unattractive, and thus likely to underperform your picks. There has to be an applicable symmetry to your investment process, otherwise you are deluding yourself that you can pick "winners", if you can't pick relative "losers" as well.

So, to hedge market, sector or industry exposure, look at your current positions. What competitors did you pass up to buy, and why? If they didn't look so attractive then, and if they've lagged since you've had your competing position, then maybe you just proved that you had relative valuation insight as well as absolute. Consider expanding your investment insights to selling short stocks that don't meet your investment criteria - if you want to lower your market exposure. If you're purely bullish, stand pat, or consider higher beta stocks that you like to get that extra oomph.

The purest expression of stock selection skill is to both buy and short stocks that you believe are mis-priced, and earn a spread between the longs and shorts, independent of the market's direction. Give it some thought. You can see how I'm doing with my long/short portfolio on Vestopia.com.

Comments

[kkin365:]

I have not a single word on "advantages" advertised in the headline to this story. A waste of my time.

2008 Feb 14 11:47 AM

[Stephen Ros...:]

I concur. If you only go long a basket of picked stocks, it's difficult to do anything but follow the ups and downs of the broad market. If you go long stocks you like and short those you don't, you avoid mimicking the indexes.

2008 Feb 15 02:11 PM

[anon:]

"There has to be an applicable symmetry to your investment process, otherwise you are deluding yourself that you can pick "winners", if you can't pick relative "losers" as well." This is one part but you must consider the payoffs as well: shorting gives you a maximum gain of 100% and maximum loss of unlimited, with a long position being the reverse. Given the payoffs, it actually makes more sense to focus on being long.

2008 Feb 15 02:33 PM

[Navodaya Ga...:]

You haven't mentioned a single advantage of shorting. Let me tell you one disadvantage of shorting, theoretically your loss can be unlimited. Instead buy some puts, if the trade goes wrong way, you loose 100% of your investment nothing more than that.

2008 Jun 16 11:11 PM