The Hidden Risks of Short Selling

Hello there,

I hope this message finds you well. Today, I wanted to share some thoughts with you about an intriguing aspect of the financial markets: short selling. While short selling can appear as a profitable strategy, there are some serious reasons why you may want to steer clear from it.

As value investors, we seek wisdom from the pioneers of our field. Consider, for instance, the perspectives of Warren Buffett and Charlie Munger, renowned figures in the investment community who are notoriously against short selling.

Buffett once opined, "It's an interesting item to study because it's so dangerous. If you're buying something because you think it's going to go up tomorrow morning, you need to have a pretty good reason why it's going to go up." Essentially, Buffett reminds us of the speculative and uncertain nature of short selling.

Munger, his long-term business partner, further substantiated this view when he stated, "It's very hard to make money on the short side. There are a huge number of people who are not being idiotic, and it's hard to bet against them, particularly when you have to pay the vig." Munger points out the practical difficulties and costs associated with shorting, making it a challenging strategy for consistent returns.

Here are five key reasons why shorting can be risky:

• Infinite Loss Potential: When you short sell, your potential loss is unlimited because a stock's price can rise indefinitely. This is in stark contrast to going long on a stock, where your potential loss is capped at the amount you invested.

• Short Squeeze: This occurs when a stock's price rises sharply, forcing short sellers to buy it back to cover their positions and prevent further loss, which, in turn, pushes the price up even more.

• Costs and Fees: Short selling involves borrowing shares to sell them, meaning you have to pay interest on these borrowed shares. This can eat into your profits or add to your losses.

• Regulatory Risks: Regulations around short selling can change abruptly, causing potential losses for short sellers. For instance, during the 2008 financial crisis, a temporary ban on short selling was enacted.

• Dividend Liability: When you short a stock, you are responsible for paying the dividends to the lender. If the company decides to issue a dividend, you will owe the full dividend amount.

Now, let's look at some statistics and facts to paint a broader picture. A comprehensive study conducted by Plus500 in 2020 found that 85% of retail investor accounts lose money when trading CFDs with this provider. This goes to show how challenging it can be to consistently profit from strategies like short selling that come with considerable risk.

In conclusion, while short selling might seem like an attractive strategy due to its potential for high returns, the risks and costs associated can be substantial. As value investors, we should focus on long-term strategies, following the footsteps of successful investors like Buffett and Munger, who have consistently highlighted the perils of short selling.

Remember, investing is a marathon, not a sprint. It's about making informed decisions based on sound principles and facts, not speculation or fleeting trends. As always, I encourage you to conduct your own research and seek professional advice as needed.

Until next time, keep investing wisely.