The Scary Side of Shorting Stocks

A client recently asked me why we don’t short stocks that are “obviously overpriced” so we can profit when their prices fall.

There are a few reasons, but the most important is that “obviously overpriced” stocks don’t always go down.

Take this chart, for example:

Source: FT

The red line represents the returns on a basket of the most shorted stocks. The blue line represents the returns on the average US equity.

I believe the basket of the most shorted stocks is a good proxy for the “most overly priced” stocks. The ones investors think are most likely to underperform. And yet, over the last few years, these stocks have outperformed the average. And since April, that margin has widened tremendously.

Low-quality, unprofitable companies have been significantly outperforming their fundamentally strong peers.

Of course, this won’t last forever. Bad companies will eventually fail, and someone shorting these companies will eventually be right. But stocks can stay irrational longer than most investors can stay solvent, and being early is often indistinguishable from being wrong.

For this reason alone, we avoid going short and recommend investors find other ways to manage risk.¹

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Happy Halloween

Unfortunately, I won’t have pictures of my kids’ costumes until later tonight. So for today’s note, you’re limited to this picture of my wife and me as Jane Goodall and a monkey.

I recognize Jane’s research was more focused on chimps, and monkeys are not chimps, but it is the thought and comfort that counts.

1. Another good reason not to be short is the fact that a bet against a stock has a maximum upside of 100% but an unlimited downside. If you think losing everything is hard, try losing 1000%.