Short Selling Stocks: A Risky Strategy You Should Avoid

Investing for the long term via broadly diversified, low cost index funds is the best way to reliably build your nest egg and work towards financial freedom. Passive investing strategies have been shown time and again in academic research to outperform active investing strategies. So there really should be no debate. The problem is that passive investing is not sexy. So, instead of extolling the virtues of a passive approach, in this post I am going to share the massive risks involved in a particular active approach to investing. Namely, short selling stocks.

My hope is that by the end of this post, you will agree that the risks involved in an active strategy like short selling stocks are just not worth the potential rewards. Especially when a more reliable strategy (although not completely risk free – no investment is!) is sitting right there waiting for you.

Let's start by talking about what short selling stocks actually is.

How to short sell a stock

Here is the basic formula to short sell:

Pick a stock that you think is overvalued at its current price. This means that you believe the stock will fall in value in the short term future.
Borrow shares of this stock at its current price. This means that you are buying the stocks on loan.
Sell the shares of stock that you have bought on the open market.
Later, when the price of the stock drops, buy those same shares back at the lower price.
Give back the same shares of stock that you initially borrowed.

Let's add some numbers here so we can see the potential advantages of a short sale:

I identify the stock price of a company called Widget Inc. as overvalued. I think this company is not run well and its stock value will fall in the next few months.
I borrow 100 shares of Widget Inc. stock at its current value of $10/share from a broker. I now have borrowed $1,000 worth of Widget Inc. stock.
Next, I sell these 100 shares on the open market and get back $1,000.
Then, in 2 months, the share price of Widget Inc. stock drops to $5/share.
I buy 100 shares of the stock at $5/share for $500.
Lastly, I give back 100 shares of the stock to the brokerage I originally borrowed from.
My profit is equal to the difference between what I earned on the open market from the borrowed shares and what I bought them back at when the price dropped. In this case, my profit is $500 ($1,000-$500).

Not too shabby…

But there is a big catch to short selling stocks

Upon initially reading this breakdown of the strategy, it can sound rather tempting. “Of course. If I just follow this formula, I can't lose,” you may think.

The only problem, and truly it is the only problem, is a big one though. This strategy requires a crystal ball that no investor actually has.

Why?

Because the strategy above requires the investor to know 2 unknowable things:

What stocks are overvalued, and
When the stock will fall in value

If you are wrong on just one of these factors, then you can lose. And lose big. For instance, even if you do in fact pick the correct stock, but it falls in value in a year instead of a few months, you can be in big trouble as your initial loan may be due before that fall in value ever happens. And if you just pick the wrong stock in general, well…the whole strategy goes caput.

And again, we know from data that active investors underperform passive investors 80% of the time. This means that, over a broad data set, your odds of picking the right stock or picking the right timing are about 20% each. Mathematically, your odds of getting both factors (the stock and the timing) correct are about 1/25 or 4%.

Those aren't good odds.

Let's illustrate this risk with another example

We will use the same made up stock as before:

I identify the stock price of a company called Widget Inc. as overvalued. I think this company is not run well and its stock value will fall in the next few months.
I borrow 100 shares of Widget Inc. stock at its current value of $10/share from a broker. I now have borrowed $1,000 worth of Widget Inc. stock.
Next, I sell these 100 shares on the open market and get back $1,000.
Then, in 2 months, the share price of Widget Inc. stock actually jumps up to $15/share.
I try to wait things out for a drop in price but my initial loan is due for prepayment in 3 months.
The stock price doesn't budge and I am forced to buy 100 shares of the stock at $15/share for $1,500.
Dismayed, I give back 100 shares of the stock to the brokerage I originally borrowed from.
My loss is equal to the difference between what I earned on the open market from the borrowed shares and what I bought them back at when the price rose. In this case, my loss is $500 ($1,500-$1,000).

And, to put salt in the wound, the price of the stock can drop in the future. But you are helpless at that point to do anything to exploit that drop.

In the end, whether you experience massive success or massive failure when short selling stocks comes down to a stroke of fate.

The juice is just not worth the squeeze

Short selling stocks seems very exciting. Because the potential risks are massive. That's why a short sale is a featured plot line in the first few episodes of the show, Billions. It's good for TV. And for the media. That's why they talk about things like this all the time.

But it isn't good for your retirement accounts and the nest egg that you have worked hard for to provide you financial freedom. By the way, you can calculate exactly how much money you need to retire right here…

The downsides are massive and statistically probable. And upsides are massive but statistically improbable. Especially in the long term. In fact, the more you play this game, the more likely you are to lose.

Sometimes, not playing at all is the best strategy

As humans, and especially as doctors, we love to tinker. Tinkering is how we make things better. When we have a sick patient, we intervene to help them.

But the opposite is true with investing in the stock market. The more we tinker, the more we risk unnecessary losses as well as incur higher fees and taxes. The less we do, the better we do. And this oxymoron can be difficult for our human nature to accept.

But our financial well-being depends on it.

My advice? Build automated habits to invest passively, ignore the noise, and enjoy your path to financial freedom. These resources can help you do just that:

You can also watch my Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here and check out my best-selling book, Money Matters in Medicine!

What do you think? Do you believe that short selling stocks works? Have you tried it? What was your experience? Let me know in the comments below!