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Karen Telleen-Lawton: Is Short Selling a Valuable Tool for the Average Investor?

Investing these days is a quagmire. With the 10-year Treasury rate below 3 percent for the fifth year in a row, bonds cannot be expected to compensate for even low inflation. So most investors are fully in the market, trying to keep current with new and old strategies like ETFs, REITs, options and short selling.

It used to be that the only people who were interested in talking about short selling were savvy investors — and they didn’t talk much. But recently, short selling has moved into the limelight. Everyone has an opinion on this practice of borrowing a stock in order to sell it, in hopes of repurchasing it when the price drops.

Shorting can be an indirect way of hedging a bet. Investopedia gives an example of an investor with a holding of large-cap technology stocks who might short the Nasdaq-100 ETF to hedge the technology exposure. They would make a lot of money if the Nasdaq-100 crashed, but their downside risk is theoretically unlimited. No matter how high the price rises, they have to purchase the ETF to repay the lenders.

For the investor, shorting is just one of many techniques an investor can attempt to make money on a stock. For the market in general, the question arises whether short selling is a valuable way to keep stock prices accurate, or whether it is responsible for unfair maligning of reputable companies.

Recently, activist investors have purchased shorts. They short a stock based on whistleblower accusations. One recent incident was kicked off by an episode of 60 Minutes in February about Lumber Liquidators. The show documented tests showing high formaldehyde levels in its laminates, which the company then denied. The following day, the stock fell 25 percent. The company ran an emergency public relations campaign, but by April the stock was worth only half of its February value, and in May, with the stock worth one-third of its pre-60 Minutes value, the CEO quit.

Of course, a television show isn’t a court of law, and activist shorts can unfairly drive down a stock price with false allegations. This is called “short and distort,” and is illegal. Nevertheless, in The New Yorker, James Surowiecki argues that activist shorts are good overall. “All kinds of forces push stocks higher: investor overconfidence, corporate puffery, and Wall Street’s inherent bullish bias,” he writes. “Shorting helps counterbalance this, and it contributes to the diversity of opinion that healthy markets require.”

Indeed, in the past decade, two studies of world markets found that the markets where shorting was allowed were more efficient and their prices more accurate.

But is it for the average investor? In my nearly 40 years of investing and fewer years advising, I have never sold short. However it is packaged, it’s still a highly risky move. However, I’ve come around to appreciate the benefits of short selling. I’m perfectly happy to sit on the sidelines while short sellers make their bets and “short and distort”-ers are prosecuted for any malfeasance. I’m perfectly happy to free ride on the nuanced information that short selling provides to the marketplace.

Trade on!

— Karen Telleen-Lawton’s column is a mélange of observations spanning sustainability from the environment to finance, economics and justice issues. She is a fee-only financial advisor (www.DecisivePath.com) and a freelance writer (www.CanyonVoices.com). Click here to read previous columns. The opinions expressed are her own.

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