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Short Selling Is A Bad Idea

I was talking with some people not too long ago and the topic of short selling came up. One person worked for a firm where he talked to customers who wanted to short sell and he knew all the logistics and paperwork of what needed to be done. Another person knew the concept pretty well, but there were quite a few folks who were completely unfamiliar with it.

The point I want you to know after reading this is that it doesn't matter, because you probably shouldn't be doing it.

What Is Short Selling?

First, I want to talk about a more common way to invest; buying long. Sounds funny, doesn't it? In industry jargon, if you go long something, it literally means to buy something. Talk about a bunch of people who try to sound more smart than they are. "I'm going long Apple" means "I'm buying Apple." The order of a long transaction matches how we buy most things in the world. First, we buy it. Then, we sell it.

Short selling, or selling short, or a short sale (we have to have at least three ways to say the same thing or it doesn't count as jargon), is just doing our more familiar transaction backward. First, we sell it. Then, we buy it. In order to sell before buying, you have to borrow it from someone. Then when you buy it back you can pay back your loan. I know it sounds counterintuitive, but let me give you a couple of examples.

Johnnie has done some research and he thinks Apple is a good investment (important: this is an example only) and thinks its price is going to go up. So he goes long English I meant to say he buys Apple. Years later Apple is worth a lot more, so Johnnie sells it for a profit.

Parker has also done some research and he thinks Amazon is a bad investment (important: this, too, is an example only) and thinks its price is going to go down. So he shorts Amazon...did it again...I meant to say he borrowed Amazon from his brokerage firm (like Fidelity or Schwab) and he sells it. A couple months pass and Amazon loses value. Parker then buys Amazon back at the lower price, returns his shares to his brokerage firm, and makes a nice profit.

Why Do People Do It?

There are a few ways shorting can be utilized in a good financial plan. For example, if you have a lot of one particular stock, either because you worked for the company or it was left to you as an inheritance, you have what is known as concentration risk. You have a majority of your wealth tied up in one company. If something happens to that company you are in trouble. You could sell it and diversify, but the tax bill would be enormous. So people would short sell the company (not allowed anymore) or the industry or sector the company is in. That way you are protected from losing money without having the tax bill.

There are many more reasons people use short selling that are bad ideas. People place bets on individual stocks and bonds, industries, sectors, and markets. If you saw the movie, The Big Short, "short" in that title was referring to these guys figuring out a way to sell short mortgage-backed securities.

Why Not Do It?

Shorting is more risky than going long (did you understand that sentence?). If you buy something, the most money you can lose is your original investment. If you spent $100 on an investment, the lowest its value can go is $0. You would lose $100. If you shorted something worth $100 hoping that the price would drop, but the price went up to $300, you would have lost $200 (bought for $300, sold for $100). If the price went up to $1,000, you would have lost $900. There is unlimited loss potential with short selling.

Further, except for a few instances that apply to relatively few people, short selling goes against many of the tenets of a good investing. You should buy investments intending to hold them for a really long time; this is especially true of stocks. Short selling is a short term bet. You should buy entire markets using mutual funds and exchange-traded funds. With short selling you are picking and choosing individual companies (although, some people do short ETFs that follow entire markets, but it's still a short term bet, which is a bad idea).

Bottom Line

Don't try to get cute or complicated. This is your financial life we're talking about here. Keep it simple and spend your time doing things that you enjoy.



About the Author

Derek Hagen, CFA, CFP, FBS, CFT-I, CIPM is a speaker, writer, and coach specializing in financial psychology, meaning and valued living, resilience, and mindfulness.


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