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All About SHORT SELLING
THE EASY WAY TO GET STARTED
By TOM TAULLI
The McGraw-Hill Companies, Inc.Copyright © 2011The McGraw-Hill Companies, Inc.
All rights reserved.
What Is Short Selling and How Can It Help Your Investing?
* Reasons for short selling
* What is short selling?
* How to short
* The history of short selling
One of the key tenets for money managers is to focus on investing for the long term. Over the years, the volatile swings will even out and your portfolio will steadily increase. By taking a buy-and-hold strategy, you should be able to generate 7 percent to 8 percent average returns—when including dividends. This is what history tends to show.
But is this really true? Can the markets be stagnant for ten or even twenty years? Yes they can. Keep in mind that the time between 2000 to 2010 is often referred to as the "Lost Decade," in which the Standard & Poor's 500 Index (S&P 500) averaged a loss of 0.5 percent per year (of course, it would have been even worse when adjusted for inflation). This did not even happen during the 1930s when the United States suffered from the Great Depression.
It is true that statistics can be misleading, as the first half of 2000 was the peak of the bull market. If the comparison was done from 2002, the numbers would look better. Yet few would argue that 2000 to 2010 was not without extreme volatility. In all, there were two major declines in the markets, which included 2000 to 2002 and 2007 to 2008. The decade also saw a variety of negative events. There was the real estate implosion, the accounting scandals of Enron and WorldCom, the terrorist strike on 9/11, the wars in Iraq and Afghanistan, and two recessions.
But can there be two lost decades? Looking back at U.S. history, there are examples of this. For example, the 1929 crash led to a grueling bear market. The Dow Jones Industrial Average (DJIA) did not recover until 1954. Another case is the period from 1964 to 1982, which also saw a devastating bear market. There is also the terrible experience in Japan. Since the plunge in the Nikkei Index in 1989, the markets are still 75 percent off from the peak.
Unfortunately, the U.S. economy is certainly facing major headwinds, which could make it difficult for the markets to post strong gains. Consider the views of top money managers at Pimco like Tony Crescenzi, Mohamed El-Erian, and Bill Gross. They believe that the U.S. economy will have a muted growth path for the long haul. One reason is that many of the jobs lost in the 2008–2009 recession will no longer return. Industries like autos, housing, construction, retail, and finance have undergone tremendous structural changes. Corporate America has also learned how to manage with fewer employees by using productivity-enhancing technologies and outsourcing to economies like China and India.
There has also been a massive destruction of wealth. Since peaking at $66 trillion, the overall net worth of Americans has fallen by about $10 trillion. This will likely be a drag on consumer spending, especially as the Baby Boomers get older and start to retire. They will focus on more conservative investments because they do not want to run out of capital. Another major drag on the economy will be increased regulations. True, the near collapse of the financial system meant that it was inevitable that the federal government would get much more intrusive. Yet this will make it more difficult for companies to operate. Despite the regulations, it is likely that U.S. financial institutions will be restrained in extending credit. The fact is the consumers still have large debt loads. What's more, with lower growth prospects, there is not as much need for credit.
The costs of the bailouts will also lead to higher taxes. At some point, the federal government will need to take action to reduce the swelling budget deficit. And in light of the surge of retirements from the Baby Boomers—which will mean higher healthcare and Social Security benefits—it will be tough to find ways to cut costs.
In light of the potential challenges—and the complexities of global economies—investors are likely to face more risk and volatility in the future. This is not to say investors need to avoid stocks or put money into ultra-safe securities like U.S. Treasuries. Instead, it means that it is important to look beyond just the purchase of securities—and consider how to make money when the values of investments fall. And of course, one effective way to do this is to use the investment technique of short selling.
MORE BAD STOCKS THAN GOOD ONES?
While any investor can have a hot streak, it typically does not last. Only a handful of investors have been able to consistently beat the markets over a ten-year period, such as Warren Buffett and Peter Lynch. Even with those who have achieved this feat—like Bill Miller—there is often a period when the returns eventually fall off.
The key to getting above-market returns is to find a few stellar performers. Picking stocks like Starbucks or Microsoft in their early years would have more than offset the losers and average performers. Lynch famously called these investments "ten baggers" (since they increased ten times or more).
Consider Li Lu, who is a candidate to manage Buffett's $100 billion portfolio. Since 1998, his hedge fund has posted annualized compound returns of 26.4 percent. This compares to the Standard & Poor's return of 2.25 percent. However, a large part of the success came from an investment in BYD, which is a fast-growing Chinese battery maker. Needless to say, it is exceedingly difficult to find these home runs. In fact, Li has found only one in his career. Actually, the fact is that—even for top investors—the chances are higher that a typical stock pick will fall in value. In other words, the odds tend to be in favor of short sellers.
This appears to be the case from a study by Blackstar Funds. The investment firm looked at the performance of all U.S. stocks from 1983 to 2006. Given that this was during a large bull market, the typical return should have been strong, right? The conclusion is the opposite. About 39 percent of the stocks were unprofitable and 18.5 percent lost at least 75 percent of their value. Only a quarter of the stocks accounted for all the value of the market.
REASONS FOR SHORT SELLING
Until recently, the topic of short selling was fairly obscure. It mostly made headline news when there was a major drop in the markets. As should be no surprise, the short sellers are easy targets to blame when things go wrong. Because of this, there are lots of misconceptions about short selling. In many investment books, the topic is rarely mentioned. And if it is, the coverage is spotty. Yet after the 2007–2008 financial panic, short selling has increasingly become a part of the investor's vernacular. As a sign of this, it has become a daily topic on CNBC as well as in top publications like the Wall Street Journal and Barron's. In fact, one of CNBC's top journalists, Herb Greenberg, often covers short-sale targets.
So even if you do not short sell a stock, it is still important to understand the conversation. You may not even realize that some of your investments may actually employ short-selling approaches. Or, by using the analytical techniques of a short seller, you may be able to avoid stocks that are vulnerable for a big fall. But if you do short sell—or want to do so—there are certainly important benefits. Perhaps one of the biggest is that short selling can lower the overall risk in your portfolio. If 80 or 90 percent of your portfolio has long positions, then a fall in the market will be partially offset by your short positions. This would have certainly be
Excerpted from All About SHORT SELLING by TOM TAULLI. Copyright © 2011 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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