Larry Swedroe: Risks Of Short Selling

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Random Walker
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Larry Swedroe: Risks Of Short Selling

Post by Random Walker » Mon May 14, 2018 8:22 am

http://www.etf.com/sections/index-inves ... nopaging=1

All of the factors are defined as long-short portfolios. One can easily correct underprocing with long only portfolios, but it is much more difficult to correct overpricing. To efficiently correct overpricing as well as underpricing can be corrected, one must have the ability to sell short. But short selling has potential for unlimited losses, there is limited supply of stocks to borrow, is expensive, and many institutions are by mandate not allowed to take part in this activity. These limits to arbitrage provide extra support for the expectation that factor premia will persist. The stocks that are hardest to short tend to have the lowest future returns. Eager to hear what others think.

Dave

garlandwhizzer
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Re: Larry Swedroe: Risks Of Short Selling

Post by garlandwhizzer » Mon May 14, 2018 3:16 pm

In theory shorting losers should add to returns but it also can increase risk substantially relative to a long-only portfolio. This risk particularly shows up in MOM where short positions in high beta stocks that have gotten killed during the a long severe bear market suddenly backfire when the market skyrockets again. The bear market's worst losers, high beta stocks, instantly become the recovery's best winners. Likewise the bear markets biggest winners, boring conservative low beta stocks, instantly are left in the dust when the market takes off, but losses here are limited in long-only portfolios. Shorting positions on the other hand have unlimited potential losses. When the turnaround is dramatic enough as it was in 2009, MOM shorts can cost you big time.

I personally can't separate future stock winners from future stock losers. I'm not sure who does it consistently well. Jim Chanos is a famous hedge fund manager who concentrates his portfolio in short-only. He shorted Enron for example and has a good reputation, but he has been predicting an economic collapse in China for a decade. He shorted Alibaba and other Chinese high-flying stocks for years and lost millions doing that. He's astute, bright, experienced, and a supposed expert on shorting, but apparently that doesn't always guarantee success in this risky endeavor.

Increased returns from shorting, if they appear at all after costs, still come at increased risk. Personally, I find the simple bond/equity balance in portfolio construction a sufficient means to set that risk/reward tradeoff for myself.

Garland Whizzer

ralph124cf
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Re: Larry Swedroe: Risks Of Short Selling

Post by ralph124cf » Tue May 15, 2018 10:35 pm

garlandwhizzer wrote:
Mon May 14, 2018 3:16 pm
In theory shorting losers should add to returns but it also can increase risk substantially relative to a long-only portfolio. This risk particularly shows up in MOM where short positions in high beta stocks that have gotten killed during the a long severe bear market suddenly backfire when the market skyrockets again. The bear market's worst losers, high beta stocks, instantly become the recovery's best winners. Likewise the bear markets biggest winners, boring conservative low beta stocks, instantly are left in the dust when the market takes off, but losses here are limited in long-only portfolios. Shorting positions on the other hand have unlimited potential losses. When the turnaround is dramatic enough as it was in 2009, MOM shorts can cost you big time.

I personally can't separate future stock winners from future stock losers. I'm not sure who does it consistently well. Jim Chanos is a famous hedge fund manager who concentrates his portfolio in short-only. He shorted Enron for example and has a good reputation, but he has been predicting an economic collapse in China for a decade. He shorted Alibaba and other Chinese high-flying stocks for years and lost millions doing that. He's astute, bright, experienced, and a supposed expert on shorting, but apparently that doesn't always guarantee success in this risky endeavor.

Increased returns from shorting, if they appear at all after costs, still come at increased risk. Personally, I find the simple bond/equity balance in portfolio construction a sufficient means to set that risk/reward tradeoff for myself.

Garland Whizzer
I think you missed the point of the article. He was not recommending that we get into short selling, but that the lack of short sellers in the market reduces efficient price discovery.

Ralph

stlutz
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Re: Larry Swedroe: Risks Of Short Selling

Post by stlutz » Wed May 16, 2018 12:10 am

Without short-sellers, equity prices can become overvalued, because only optimists are expressing their opinions on valuations.
This doesn't really make sense. Choosing not to buy expresses a negative opinion, not a neutral one. If nobody wants to own something, the price goes to zero. No short selling required.

Generally institutions who aren't allowed to borrow to sell aren't allowed to borrow to buy either. Conversely, those who can short can take a levered long position as well.

Random Walker
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Re: Larry Swedroe: Risks Of Short Selling

Post by Random Walker » Wed May 16, 2018 9:39 am

But the simplest example is us individual investors; very easy for us to go long and very difficult to go short.

Dave

lack_ey
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Re: Larry Swedroe: Risks Of Short Selling

Post by lack_ey » Wed May 16, 2018 10:30 am

stlutz wrote:
Wed May 16, 2018 12:10 am
Without short-sellers, equity prices can become overvalued, because only optimists are expressing their opinions on valuations.
This doesn't really make sense. Choosing not to buy expresses a negative opinion, not a neutral one. If nobody wants to own something, the price goes to zero. No short selling required.

Generally institutions who aren't allowed to borrow to sell aren't allowed to borrow to buy either. Conversely, those who can short can take a levered long position as well.
The premise is that the optimists are the ones buying and holding, or perhaps selling to each other.

Let's say the market range of opinions on a stock is somewhere between $5 and $15. Maybe it trades at $12. The issue is that there's a whole range of people who think $12 is too high, some who think it's a little expensive for them and those who think it's way overvalued at that price. Index funds buy in at $12 because that's the market price.

If short selling is possible, instead those who are thinking $5 or $6 might short sell, bringing the price down closer to more of the average, which let's say is around $10. This allows a fuller range of opinions and analysis to go into pricing. Without short selling, it doesn't matter how many people think $5 as opposed to $7 or $10. They all don't want to buy at $12.

This is not as important where the crowd is driving pricing and the spread of opinions is smaller, but it can play a role sometimes. A different stock also trading at $12 where opinions range from $10 to $13 is in a good spot. This should have a higher price than the other one.

Underweighting a stock that is 0.01% of the market is a negative opinion, but not a strong one. 0% is not much different from 0.01%. If some people here or there want to own 2% or 5% of their holdings in that stock, that would be a strong opinion on the other side.

stlutz
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Re: Larry Swedroe: Risks Of Short Selling

Post by stlutz » Wed May 16, 2018 10:43 pm

Relative to the overall market, this board is pretty optimistic. The overall global stock/bond mix is about 40/60, but around here 60/40 is looked at as fairly conservative and everyone is implored to "stay the course" when they are thinking about dumping their stocks because the market dropped, because PE 10 is high etc. So, index investors aren't necessarily representative of the entire market.

My point is the simply that the people who can't short also can't lever up their long position. To use lack_ey's example, some of the optimists might want to go 2x on their long position if they think the price actually should be $20, but they can't because their investment policy doesn't allow them to. Or the might just be an individual investor like me and they don't have a margin account and they don't have options trading permission. :happy

I guess I'd be interested in a look at such investment policies and their impact on market pricing as a study in itself as opposed to throwing it around as as logical sounding reason for why a past anomaly must persist.

CurlyDave
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Re: Larry Swedroe: Risks Of Short Selling

Post by CurlyDave » Wed May 16, 2018 11:46 pm

So short sellers are necessary for efficient markets. I can understand that.

But even back in the olden days, when I was trading individual stocks, I never had any desire to short anything. Sure, people make money doing it, but as one investor in a huge market I could always find plenty of opportunities to invest in. And selling a stock in order to better allocate that money to a better stock is about as much of a vote of no confidence as I wanted to make.

This is sort of like the story about the cesspool and the castle. Nobody likes to think about the cesspool under the castle, but without it the magnificent castle would be uninhabitable. Shorting stocks is the same thing -- it has to be a possibility, but I don't have to go down there and get my feet wet in it in order to benefit from its existence.

Ron Scott
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Re: Larry Swedroe: Risks Of Short Selling

Post by Ron Scott » Fri May 18, 2018 10:02 am

stlutz wrote:
Wed May 16, 2018 10:43 pm
Relative to the overall market, this board is pretty optimistic. The overall global stock/bond mix is about 40/60, but around here 60/40 is looked at as fairly conservative and everyone is implored to "stay the course" when they are thinking about dumping their stocks because the market dropped, because PE 10 is high etc. So, index investors aren't necessarily representative of the entire market.
This is a really good point for us to keep in mind as there is an underlying assumption that posters are representative of the Bogle's approach or at least of the general population of passive investors. Not so. Posters here stick closer to the marketing literature of the investment houses than to Bogle.

I believe Bogle writes he's a 50-50 investor and touts Graham's recommendation to keep between 25% and 75% in stocks. These guys would be perfectly comfortable recommending 30-70 to a conservative.

The large investment houses market 40% stocks as being conservative and that's pretty much where this board is.

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