My favorite way to pass the time on my daily commute between my home in Lowell and our office downtown is to listen to podcasts as I drive. One of the best that I have found is Planet Money, a team at NPR that produces short stories about the global economy. In my line of work I spend a fair amount of time consuming information about the financial markets and the economy from a broad range of sources, and I am continually impressed at how this team can take what is often regarded as a dry or very technical topic and make it fun and approachable.
In that vein, check out their recent series on short selling (see the link at the bottom of this post). Most people have heard of short selling stocks but it’s such a counterintuitive idea that it can be a challenge to understand the mechanics. If you think about it, even after the roller coaster ride that the economy has taken us on over the past ten years and the heightened level of apprehension with which many investors approach the stock market today, most of us are still effectively taking the optimistic view – by owning a house and a retirement account, we are betting that values are going to go up over time. History has shown us time and again that this is a smart bet.
When it comes to individual companies, though, there are more sides to the coin. Short selling comes into play when there are widely divergent views of a particular company’s stock. Typically if you don’t feel confident about the outlook for a particular company, you simply would avoid holding the stock at all. Investors that sell the stock short do so when they actively believe that something unique about the company will cause its value to decline, at odds with the broader market. Short selling can be dangerous because there is essentially no limit on how much you could lose – the stock price could go up indefinitely.
While short selling is undoubtedly a risky tactic when viewed in isolation, it can play a useful role in a portfolio context as part of a long-short strategy that pairs short selling with traditional buy-and-hold “long” positions that are expected to grow in value. Most long-short equity strategies still keep a net long position to the stock market, meaning the risk of losses from the long holdings is only partially offset by the short positions. These characteristics make long-short strategies an attractive component of a diversified equity portfolio because they typically have lower volatility than long-only investing and can act as a partial hedge when the market declines.
Long-short equity strategies appear particularly opportune today when we take a look at the state of the U.S. stock market. It has been over six years since the market bottom and three and a half years since the last short-term correction, and although the underlying economy appears solid, increased volatility and greater divergence from company to company seems likely. A disciplined long-short strategy managed by a team of experienced stock analysts can be an effective way to take advantage of current market conditions while placing an emphasis on risk control.