Related topics: stocks, economy, shorting, stock market, Bill Fleckenstein
As I have mentioned several times this year, I am expecting the market to run into headwinds at some point this year, potentially serious ones. With so many problems festering beneath the surface, it is impossible to say which one (or which combination) might be the catalyst to start a downturn. And, as always, the exact timing is unknowable.
If that happens, some folks may be tempted to look at shorting stocks -- betting that they will go down -- as an "easy" way to make a few bucks.
While shorting can make you money, it is anything but easy. So it is in that spirit that I want to revisit a column I wrote in 2002 about the perils and pitfalls of life on the short side. Here's an updated version of that column:
The perils of playing it short
I'd like to devote this column to a discussion of short selling, in the hope of answering at least some of the many questions I receive on the subject. Let me be clear from the outset: My goal is not to advocate short selling but to differentiate it from investing on the long side and to highlight what I think are some of its complexities and complications.
The reason I offer this caution is not any belief that people at home are not smart enough to short stocks (I'm sure they are), but rather because of the time-intensive "babysitting" involved in monitoring positions, which is almost impossible for nonprofessionals to do.
Bill Fleckenstein
Also, my approach is just the way that works for me, after many years of working the problem; other successful short-sellers do it differently.
The long answer
First of all, let me preface my thoughts with some comments on the value approach to investing. When investing on the long side (as I have done in the past and will do again in the future), I am a value investor. Without going into everything that means, the one thing it allows for is averaging down as your initial investment "goes against you." Many, many times in my career, I have successfully averaged down in positions. If you're confident from your research that you are not averaging down into a WorldCom, an Enron or some other debacle, averaging down allows you to enhance your rate of return.
For instance, suppose a stock that you're interested in is selling for $50 and, for whatever reason, you think it could go up to $100. If the stock drops to $40 and you decide to buy it because you are confident that the value is there -- and that the perception of problems is overblown -- and it then goes to $100, obviously you're going to make 150% on your money.
But let's say, in the same situation, you don't buy it when things are looking rather bleak but instead wait until the situation improves somewhat. Perhaps you pay $60 for it, so you are paying up only 20%. If the stock goes to $100, your rate of return is going to be 66%. So there is just one example of how, if you're confident that your analysis is correct, averaging down into bad news really helps your rate of return.
The price of success
Now, let's segue to the short side, where averaging up blindly can lead to disaster. Before going any further, I'd like to introduce one other element here: In the art of speculating in commodities, price action means almost everything. Commodity traders call it "price discovery." Successful commodity speculators don't often average up or down as the price goes against them (preferring to "average in," as the price goes in their favor). They might add to their positions a little bit as the price goes against them; however, when faced with a big move against them, they generally close a position and re-enter at a later period. Fundamentals do matter in commodity speculation, but price action tends to be a much bigger factor, at least for people who are successful. The aspect of price action is much more important in commodity speculation than it is for a value investor on the long side.
As you can see from my previous example, I don't put much faith in price action when I am an investor on the long side. But on the short side, it is often necessary to cut and run if, say, you short a stock at $20 and soon after it goes to $25, for reasons that you don't understand or which really shouldn't be happening. Often, it's wise to reduce your position, or eliminate it entirely, and then revisit the subject at a future date, whether that might be later that day, a week later, two weeks later or a month later.
Believe me, that was a hard and expensive lesson to learn, and it's difficult for anyone who comes from the value school, in my opinion. Also, I would point out that this is not necessarily the way everyone does it, just the approach that I have found to be successful.
