Short-selling shares can protect you against market falls but don't get hooked. A Fool writer confesses all and reveals a way through the traps.
I love short selling shares. There's a perverse enjoyment in not just saying that a company is way overpriced or just a load of rubbish but in making money from being proved right.
I placed my first short eight years ago – KPNQwest, a telecoms company with massive debts in an overcrowded sector. I made a crazy amount of money in three months. I was ecstatic but I later learnt that this sort of easy initial success is known in investing circles as "the worst thing that can happen." I wasn't aware that greater powers than me had given up playing at this particular table.
"I had a harrowing experience shorting a stock in 1954. I wouldn't have been wrong over ten years, but I was very wrong after ten weeks, which was the relevant period. My net worth was evaporating" confesses one Warren Buffet.
Buffett explains the central problem with shorting: "Everything we've ever thought about shorting worked out eventually, but it's very painful. It's a whole lot easier to make money on the long side. You can't make big money shorting because the risk of big losses means you can't make big bets."
It wasn't for eighteen months that I started to get really cocky and rack up some choke-on-your-Dom Perignon size losses. I still didn't learn my lesson until mid 2006. My absolute conviction that the UK housing market was cracking (and not in a good way) led me to keep increasing my already very large short on Countrywide estate agents.
Only when the price had doubled did I see that I had made a very great error. This was not in shorting Countrywide (we all get calls wrong) but in not allowing that I might be wrong. My overconfidence, arrogance and greed led me to keep placing bets on Countrywide when I should have stopped. Every time it rose a pound I thought "it can't go any higher." It did.
Nursing my considerable but not fatal wound I went on the shorting wagon for a while. I've gradually gone back into the game and this has protected me against some, but not all of the recent market falls. I have kept my shorts pretty small compared to my portfolio so I'm not getting jackpots or crazy losses any more.
When driving near a cliff, keep in first gear
If you want to take up shorting my advice is – don’t. If you insist then you must do as much as you can to prevent a grenade detonating in your hand.
1. Stick to small measures and don't double up just because the price is going up
2. Stick to businesses you can understand
3. Avoid shares where the range of possible valuations is large or where a single event can multiply the value of the company
4. Avoid a situation that may be a promotion unless it's already hit the rocks
A promotion is the pushing up of a share by legal and very often illegal means. The share is usually small, not long established and has allegedly great prospects.
Here's Buffett again: "You'll see way more stocks that are dramatically overvalued than dramatically undervalued. It's common for promoters to cause a stock to become valued at five to ten times its true value, but rare to find a stock trading at 10-20% of its true value. So you might think short selling is easy, but it's not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it it's worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, 'Hey! Look at all that value creation!' and the game goes on. [As a short seller,] you could run out of money before the promoter runs out of ideas."
If you have any views on shorting or have shorted yourself, then let us know with a comment on the bottom of this article.
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