Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Tesla Motors Inc (TSLA), Kinder Morgan Inc (KMI) & Why Being Wrong Could Be Your Ruin

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%.

Tesla Motors Inc (NASDAQ:TSLA)

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.

DOWNLOAD FREE REPORT: Warren Buffett's Best Stock Picks

Let Warren Buffett, George Soros, Steve Cohen, and Daniel Loeb WORK FOR YOU.

If you want to beat the low cost index funds by 19 percentage points per year, look no further than our monthly newsletter.In this free report you can find an in-depth analysis of the performance of Warren Buffett's entire historical stock picks. We uncovered Warren Buffett's Best Stock Picks and a way to for Buffett to improve his returns by more than 4 percentage points per year.

Bonus Biotech Stock Pick: You can also find a detailed bonus biotech stock pick that we expect to return more than 50% within 12 months.
Subscribe me to Insider Monkey's Free Daily Newsletter
This is a FREE report from Insider Monkey. Credit Card is NOT required.