Randall Hsu's  Instablog

John Maynard Keynes said, "Markets can remain irrational longer than you can remain solvent." My biggest investment mistake was trying to go short on high-growth companies with rich valuations, such as Green Mountain Coffee Roasters (GMCR), Lululemon Athletica (LULU), and Deckers Outdoor (DECK). I learned that an individual security could remain overly pessimistic or optimistic for a period of time due to the market sentiments, and the best course of action is to focus on securities with depressed valuations and simply step away from securities with expensive valuations.

In the long run, the market is a weighting machine that should reflect an individual security's true worth, such as the recent revaluation of Green Mountain Coffee Roasters. However, by going short on a security, there are serious disadvantages making this operation unfavorable when compared to investing in a security with depressed valuations.

First, by going short, I have to borrow shares from other owners. This puts uncertainty on my holding period. I could be forced to cover in a short notice. Second, going short is subject to margin call. Unlike buying a depressed security with reasonable margin of safety, where a further decrease in price presents even better investment opportunity, shorting a security is subject to margin call when the price goes up, and I would be forced to cover my position instead of taking advantage of the situation. Finally, by going short, I have neglected the power of compound interest, which is the most effective method to building wealth.

Great investors like Warren Buffett did not try to short Internet companies during the Dot-com bubble. He focuses on companies that can reinvest profits at excellent rates over a long period of time, and this is a superior policy to allocating capital than going short.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.