Markets

The Dangers of Selling Short

The odds are stacked against you. The economy grows, and so do companies that take part in it.

By James K. Glassman, Contributing Editor

From Kiplinger's Personal Finance magazine, December 2007

Think of this technique as picking the winner in a two-horse race. You don't have to guess the speed. Even if the market crashes, as long as Motorola beats Nokia, you succeed.

This approach sounds easier than finding an entire portfolio of stocks that are about to tank, but it's still extremely difficult -- again, because stocks tend to be efficiently priced. (For example, Motorola may be a better company to invest in than Nokia, but its valuation currently reflects that difference: In early October, it carried a P/E of 33, while Nokia's was 18.)

The Enron example

Successful short-sellers thrive by zeroing in on stocks that are misunderstood by the market -- often because managements aren't forthcoming about their firms' true financial condition. The classic case was the assessment of Enron by James Chanos, a short-seller whose research in 2000 and 2001 found that the energy company's return on capital "was a paltry 7% before taxes," as he later told a congressional committee. Chanos also became suspicious of some "related-party transactions" that Enron had reported to the Securities and Exchange Commission and of the abrupt resignation of its chief executive officer, Jeff Skilling. A few months later, Enron's managers admitted to overstating earnings, and the company filed for bankruptcy protection. In a year, the stock fell from about $80 per share to less than a buck.

This game may have become tougher in the age of Sarbanes-Oxley because executives can receive long prison sentences for cooking the books. Still, short-sellers can drive down stock prices -- or try to -- by spreading rumors and planting stories with friendly journalists about a firm's possibly perilous state.

Shorting stocks is a tough way to make a living. If the company you short performs the way the market as a whole has performed for decades, then its share price will rise 10% annually. Thus, after four years, a company that was shorted at $20 is worth about $29, and you've lost about half your investment. Think of playing at a casino where the house take is more than 10% on your bets, and you get the idea.

The best evidence that betting on losing is futile is the performance of mutual funds that specialize in the endeavor. Perhaps the best-known is Prudent Bear fund, with total assets of about $800 million. The fund, founded by Dallas money manager David Tice in 1995, sells short not only the broad market (the S&P 500, Russell 2000 and Nasdaq 100) but also, at last report, about 60 individual stocks. The fund also takes some long positions, with a preference for precious-metals stocks. For the five years ended October 5, Prudent Bear produced an annualized loss of 4.4% -- roughly 20 percentage points worse, per year, than the S&P 500 and an average of eight percentage points per year worse than owning a medium-term U.S. Treasury note.

As dismal as Prudent Bear's numbers are, you have to admire Tice. If he were simply shorting the S&P 500, his shareholders would have lost an annualized 16% over the period -- plus the fund's hefty expense ratio of 1.8%.

A two-fund portfolio

The point of this column is not simply to discourage you from shorting stocks but to emphasize how wonderful the normal, straightforward approach of buying stocks can be. Buy what? Well, the market as a whole is not a bad choice. Vanguard Total Stock Market (symbol VTI), an exchange-traded fund that reflects the performance of all publicly traded U.S. companies, returned an annualized 17% for the five years ended October 5. And iShares MSCI EAFE (EFA), which mimics the Morgan Stanley index for non-U.S. markets, returned 24% annualized. Vanguard's fund carries an expense ratio of just 0.07%; iShares' fund is 0.35%, still a nice deal. You could do a lot worse than splitting your investments 50/50 between the two and staying away from the short side forever.

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