by Archie M. Richards, Jr., CFP^®
September 30, 2002

With investors now so pessimistic, some of them are talking about selling short. I don't want you actually engage in short selling, but here's what they're talking about:

You sell short in anticipation of the stock price going down. It's the opposite of buying long.

"Wait a minute," you say. "Wouldn't I have to own the stock first?"

No.

"How can I sell something I don't already own?"

You borrow the stock from a broker. The broker, in turn, borrows it from an investor who holds it on margin. The investor-owner is unaware that his stock is being lent. But the margin agreement he signed authorized the borrowing. The broker doesn't charge interest, but he does charge commissions.

"Okay, what happens next."

You sell the stock in the market, say, 500 shares. The buyer doesn't know you're selling short. You're selling because you expect the price to fall. The other guy expects it to rise. Eventually, you may both be right.

Let's assume you turn out to be correct. The price drops. From a third party, you buy 500 shares. It's called "covering" the short. Since every share of stock of a company has exactly the same value as every other share, you don't have to buy from the person to whom you originally sold it. You bought low and sold high, only you did the selling first.

"Let's see," you say. "I expect the stock price to fall. I borrow the stock, sell it short, cover the short at a lower price, and repay the loan. Sounds like a piece of cake."

It isn't. Selling short is much too risky. Don't do it, ever. When you buy a stock without borrowing the cash, the worse that can happen is that the price goes to zero and you lose all your money. But when you sell a stock short, there's no limit on how far the price can rise and how much you can lose. I have only twenty fingers and toes, but they tell me infinity is pretty high. As the price goes up, you have to keep adding cash to the account as collateral against the stock you borrowed.

"Throwing good money after bad, eh?"

Exactly. And the numbers are rigged against you. When you buy a stock at 50 and it rises to 100, you have a double. But when you short a stock at 100 and it drops to 50, you make only 50 percent. To profit 100 percent on a short sale without margin, the price must fall to zero. To preserve their jobs, the company's employees are doing everything they can to prevent this.

The fellow who originally owned the stock may have agreed to lend it, but he didn't agree to give up the dividends. The dividends are now being paid to the person you sold to, the new owner. The original owner can't be left empty-handed.

"Who pays him the dividends?"

You do. When you buy a stock long, you receive the dividends. But when you sell a stock short, you pay them. The cash outflow adds up, believe me.

Do not sell short on the assumption that pessimism will drive stock prices further down. The market doesn't work that way. Pessimism keeps increasing as prices keep going down. It's greatest when the prices reach bottom. No one knows when this is at the time. But if you happen to sell short then, when pessimism is rampant, the price will move up against you, and you'll be left holding the bag.

No one can predict down markets consistently. Rely on what you do know, namely, that over longer periods, stocks perform better than anything else. Invest the boring way. Buy index funds that track thousands of the world's stocks and hold them indefinitely.

For well-diversified, long-term buyers, the stock market is the Garden of Eden. Short selling is forbidden fruit. Engage in it, and you'll end up losing a rib.