What Short Sellers Do — and Why Your Portfolio Benefits Whether You Know It or Not
Most investors focus on what to buy, but professional short sellers make their living finding what's likely to fail — and their research might be useful to the rest of us.
Imagine you wanted to bet on the winner of a sporting event, but you could only bet on one side to win. If you don’t think that team will win, your only choice is not bet, while others that believe the team will win are free to place their bets. The odds might shift so that it seems more likely the one team will win, simply because no one can bet against them. In investing, without the ability to sell stocks short, your only choice is to buy shares if you don’t already have them, sell them if you do, or do nothing.
Professional short sellers pore over the financials of businesses, interview employees and suppliers, and look for signs of decline and fraud. Betting against these companies is difficult. While it is possible to sell shares of stock short, effectively betting the share price will go down, there are plausible reasons to believe that the prices of these companies could be too high. One is that many investors do not have the risk tolerance to short stocks. Shorting stocks has unlimited downside, with 100% upside at best. Being long (owning stocks) has unlimited upside and only 100% downside. Another is that some stocks are "hard to borrow."
In order to short a stock, an investor borrows shares from another investor and sells them to yet another investor. In a sense, two investors own the same shares, and the short investor owes someone the shares. The short investor is hoping she can buy back the shares later at a lower price than what she sold them for. The first investor — the one lending the shares he owns — doesn't lend them for nothing. He receives interest and any dividends for lending the shares. This market for shares to borrow is subject to supply and demand. When many investors want to borrow shares of a company, or that company has few shares available, the interest charge to borrow shares to sell short can be very high. The short seller can be right, but still lose money if the stock doesn't drop more than the borrowing cost or the stock takes a long time to drop. For this reason, it's possible that there would be more short sellers helping to push prices down on certain companies if not for these challenges.
What does this mean for you? Most individual investors can't and shouldn't short stocks, but understanding the mechanics helps explain why you sometimes see companies that seem highly overvalued, even for extended periods of time. Owning a highly diversified portfolio helps avoid concentrating in these companies, and utilizes the collective wisdom of all investors. Short sellers are often maligned in the media, but they serve a valuable purpose in unearthing frauds and keeping valuations in check. Even though you aren’t paying them, they are helping to protect portfolios from potential hazards.
If you're curious how portfolio construction accounts for dynamics like these, that's exactly the kind of conversation I enjoy. Book a free call.
This content is for educational purposes only and does not constitute personalized investment advice. Past performance is not indicative of future results. This post discusses short selling for educational purposes only. Short selling involves substantial risk and is not suitable for most investors.