On Short-Selling Stock

Currently, economies the world over are struggling to piece themselves back together in the midst of a recession triggered by the United States’ near economic collapse from 2007-2009.

According to Frederic S. Mishkin (a member of the Board of Governors of the Federal Reserve System from 2006-2008), the reason for the severe economic collapse in the U.S. was tied to what is often described as a housing/real-estate ‘bubble’ that saw a “…rapid rise and subsequent decline in residential pricing.”

When the American real-estate bubble burst, financial institutions all over the world began to suffer, leading to the collapse and restructuring of many large financial institutions. Most notably, on Sept. 15 2008, financial services firm Lehmann Brothers filed for bankruptcy with $613 billion worth of debt.

The severity of this economic downfall has led governments the world over to investigate questionable trade practices and to question those firmly entrenched in the financial services sector.

On Sept. 18 2008 (three days after the Lehmann Brothers collapse) New York Attorney General Andrew Cuomo launched a ‘wide-ranging’ investigation into the practice of short-selling in the financial markets.

Short-selling is (generally) considered as the act of profiting from a decline in price of a certain asset. How this system works is a short-seller borrows a certain number of stocks from a broker and sells them at the current market price with the expectation that the value of the stock will decrease.

After the initial sale, the short-seller then buys back those same shares at a lower price than what they had been sold for. The shares are then returned to the broker, and the short-seller has made a profit. Here’s more in a great video from Michael Fischer of Saving and Investing:

The risk with short-selling is determining whether or not a stock price will rise or fall. If the stock falls, as desired by the seller, then a profit is made. However, if after the initial sale by the seller, the price rises, then the seller has to buy back the stocks at a loss.

Short-selling is a highly-controversial trading practice. While in the midst of economic decline the U.S. government took aim at the practice suggesting that it destabilizes the market, although many in the financial sector believe it does benefit the market.

In 2006, at the annual meeting of Berkshire Hathaway (an investment firm run by famed financial investor Warren Buffet), Mr. Buffet was asked about his thoughts on short-selling, suggesting that short-selling had proven useful in discovering fraudulent or semi-fraudulent companies.

In September 2005 a study was published by a trio of researchers at Duke University that found “…short-sellers target stocks where the market has over-estimated the fundamentals (such that these firms will experience poor operating performance in the future, which has been shown to be associated with negative returns).”

In other words, short-sellers may be good at predicting the future performance of a stock by targeting companies with weak economic fundamentals.

Where one view of short-selling suggests that it creates market instability and fosters dangerous trade practices, the other suggests that the practice helps to determine both the legitimacy of a company and to predict its future value.

With limited and calculating use, short-selling can benefit the market by finding the ‘real’ value of a company. However, without proper oversight and control, short-selling creates serious market instability that puts financial institutions, companies, and the economy at risk.

Have you ever practiced any short selling? What do you think about it? Is it an irresponsible investing strategy?

(Author: Wasim Salman)