How short-selling can help or hurt your portfolio
What is short-selling?
The vast majority of the investing industry is geared towards enticing investors to buy good-quality companies with honest management teams, clean balance sheets and solid future prospects with undervalued share prices.
Short selling allows an investor to profit from taking a contrarian view, as in the 2400 companies listed on the ASX there are a number that have low or negative growth, high and increasing debt levels and a weak business model and are overvalued by a market.
Short sellers will then borrow stock from a stockbroker and sell it, essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back.
For institutional investors the costs are lower than those faced by retail investors.
Institutional investors are able to borrow stock at very low rates from index funds, whereas retail investor must establish a short exposure to a stock by using contracts for difference (CFDs).
How can it help a portfolio?
Short selling can be profitable if the investor correctly predicts which stocks will decline.
Often investors in their daily life come across situations where there is a substantial gap between how the investment analysts (ensconced in their ivory office towers) view a company's prospects and how that company is actually performing and treating its customers.
Late last year a visit to the Dick Smith store in Sydney's Bondi Junction to buy a Fitbit revealed large amounts of drab home-brand inventory, disinterested staff and an empty store.
As it didn't stock the item that I was after, my business - as with many other shoppers - went to Harvey Norman and JB Hi-Fi.
Here retail investors can profit by taking a view on a company that was clearly underperforming both market expectations and its peers.
How can it hurt a portfolio?
However, it would be wrong to think that short selling risky stocks is a smooth path to outperformance.
If the stock sold short rises sharply, the lender may require additional collateral or require the short seller to buy back the stock to close out their short before your planned time frame.
This gives rise to the skewed payoff ratio from short selling where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite.
See the chart on the payoff matrix we faced when shorting Slater & Gordon (ASX: SGH) at $5 in mid-2015.
While the Slater & Gordon trade was profitable for us, we monitored it very closely and closed the position out at 90 cents (far above the current share price) as we considered that the risk-reward opportunity had narrowed too much.
Given the potential downside we would only recommend short selling to individual investors who have an exceptionally high level of knowledge in a particular sector or stock.
As the father of modern macroeconomics, John Keynes, once famously said, "markets can remain irrational a lot longer than you and I can remain solvent''!