There are a few things that I have never made money doing. Someday, I will devote an article to the appalling losses racked up buying baseball cards as an investment when I was a kid. On a percentage basis, that was easily my worst investment. On a dollar basis, that financial error pales in comparison to buying residential real estate in Virginia – a mistake I apparently didn’t learn well enough the first time, so I repeated it nine years later when the Army moved us back to Virginia. There are certainly other financial errors I’ve made, but as with stocks, the downside is always limited to the amount I invest. Indeed, there is one area where I’ve never been tempted to dabble: shorting individual stocks.
While I didn’t understand the laws of supply and demand as a twelve-year-old collecting baseball cards or the pernicious nature of fees related to buying and selling real estate when we regularly moved on military orders, I have always intuitively known that shorting stocks was a bad idea. The reason is conceptually very simple.
If I am right about shorting a stock, my upside is roughly double my initial investment. If I sell Stock A short at $100 per share, and the company goes bankrupt, I will make $100 on each share I sold short when I buy those shares back. Except, of course, it’s unlikely I would hold the stock until it reaches $0 for two reasons: First, the stock would almost certainly be delisted before it actually went to $0; second, human nature would compel me to take profits way before that point.
If I am wrong about my short position and the stock does not decline but instead goes up, my downside is infinite. That $100 stock could have been Berkshire Hathaway in the early 1970s, which is now worth roughly $390,000 per share.
From a risk/reward perspective, doubling your money versus unlimited losses is just about as bad a deal as there is. Indeed, the number of investors who have ruined their reputations short-selling is nearly as infinite as the downside they expose themselves to by shorting equities.
David Einhorn and Jim Chanos have been crushed by their bets against Tesla. Melvin Capital famously blew up shorting GameStop. Bill Ackman’s battle against Herbalife ended a few years ago when he finally cried “Uncle.”
These Wall Street geniuses received Ivy League educations and are obviously not dumb, but intelligence isn’t the most important thing when it comes to making money investing. Limiting behavioral traits like fear and greed as well as a propensity to gamble trade are far more important. In other words, I believe patience is a more critical skill than intelligence – patience to allow companies and the market writ large to compound over time.
Sure, there are times when short selling works out very well for the investor, and the stocks of Tesla, GameStop and Herbalife may indeed be extremely overvalued such that these famed short sellers were simply early. But, early is the same as wrong when one’s investment thesis continues to be wrong for any extended period of time. Moreover, if these titans of finance can’t differentiate a Ponzi scheme from an apparently sound business that produces an incredible vehicle, what chance do regular folks have to successfully make similar analyses?
I’m fairly certain I would have understood that textile manufacturing was dying in the early 1970s. The trend away from expensive American labor to cheaper international labor was well underway by then. If I had been alive and an avid short-seller, perhaps I would have come across a well-known textile company out of New Bedford, Massachusetts, and I too would have been certain that Berkshire Hathaway would inevitably fail.
Thank you for reading. -John
