Selling stock shorts can be fun and profitable, but it’s a very risky strategy. Most stocks go up, the cost of being wrong is huge, even being right might not be profitable, and brokers charge big fees for you to short. If you’re not an experienced investor who understands all the risks, then you probably shouldn’t be selling short.
1. Swimming upstream
The most obvious, but perhaps most important, challenge in shorting is that, on average, stocks go up. Not every stock, and not every year, but the general trend is upwards. According to data from NYU-Stern Professor Aswath Damodaran, stocks in the S&P 500 have advanced, on average, 9% annually between 1928 and 2012. Thus, if you choose to short stocks, you’re betting against the odds and history.
2. Being wrong could be your ruin
It’s often pointed out that shorting offers a maximum return of 100%, with unlimited potential to lose. In practice, your potential losses aren’t unlimited (your broker wouldn’t allow that), but you could completely wipe out your account. In other words, if you’re wrong, you could lose everything. That’s a pretty big risk, considering it’s very possible that you could be wrong. In investing, nobody is right all the time. Even Warren Buffett has made mistakes and lost on investments.
Here’s a real-life example of how it’s really easy to be wrong. Let’s say you were examining a company about a year ago. The company had generated large losses for five years. Its strategy was to enter an industry dominated by a few huge incumbents, which had dominated the industry since World War II or earlier. The company was developing an entirely new, very complex product from scratch. The endeavor would require huge amounts of capital, and the company’s ability to raise further capital was unknown. Finally, the size of its target market was uncertain. At best, it would cater to a large niche, and at worst, nobody would want it’s products. Its founder and CEO was talented but also invested in other non-related projects. And this company had a market capitalization north of $3 billion. A reasonable analysis might have suggested that this company was a money-loser, it was on a quixotic mission, and it would never succeed. In other words, a good short candidate. That’s what a lot of professional, well-informed investors thought at the time — short interest on the company was nearly 30%.
If you hadn’t already guessed, I’m talking about Tesla Motors Inc (NASDAQ:TSLA), which is up more than 460% over the past year. Elon Musk and company defied the odds and met or exceeded challenging milestones, and market sentiment shifted radically. The stock went on an incredible bull run, perhaps with a few short squeezes along the way. If you had shorted the stock, you would’ve been destroyed. Even though your initial case against would’ve been completely reasonable, it didn’t work out. You were wrong, along with a lot of other investors. And, since it was a short position, your losses would be catastrophic. Obviously, this is a cherry-picked example, but it illustrates the huge risks associated with shorting.