Summary What separates investing from gambling? Positive expected value. Short-selling has a negative expected value – more negative than some casino games. What are you optimizing? In theory investing is about optimizing return, but many investors’ behavior suggests they are optimizing/minimizing something else. For some heavy short-sellers, it’s intellectual stimulation. I don’t think short selling is right for me or most investors, but this is just my still-evolving opinion. Full disclosure: I’ve never shorted a stock in my life. As such, I’m probably terribly biased and not credible. Short selling is betting that a stock or security will go down. Instead of buying low and selling high, you first sell high and then buy low. You do so by borrowing someone else’s shares when you initially sell and then replacing those shares later on by buying them. For reasons I will explain in this article, I don’t think most investors, including myself, should engage in short selling. Some should, but even for those for whom short selling (“shorting”) is appropriate, it probably should not be used as a primary strategy. This argument has been hashed out many times. I could repeat what’s been discussed many times. For example, when you engage in shorting your upside is limited and downside unlimited – the unfavorable reverse of going long. Instead, I will focus on what I see as the most important points for me and perhaps where I’ve added some original thought. When you short-sell a stock, the odds are against you What separates investing from gambling? Sure, investing isn’t done in a casino, it’s much more calculated, there’s far more money in it, etc. The biggest difference though, is that when you gamble, there is a negative expected value – the odds are against you. The casino takes a cut. When you invest, there is no golden rule saying it has to be a favorable bet, but equities in the US have been increasing rather consistently for over 150 years (see Jeremy Siegel’s excellent book Stocks for the Long Run ). Studies of “rules-based” systematic investing styles like buying the lowest 10% of the market by EV/EBIT and rebalancing annually will often include the returns of the opposite decile (the highest 10% of the market by EV/EBIT in our example). The idea is that the larger the gap in returns between the two poles, the more predictive value the metric has. So what’s the point? Well when you look at these studies, it’s surprisingly hard to find one where the worst decile is actually delivering negative returns. This is significant because it means that stocks don’t only appreciate substantially on average, it’s also hard to find some that will go down at all. For myself and presumably many other investors, this odds-against-you fact is a total deal breaker. I remember in high school, I would print out the Las Vegas odds of each weeks NFL games and offer to do straight bets with anyone on any game so long as I had the favorite. I was okay with this activity because by picking the favorite without paying for it, I had a positive expected value – even though I didn’t know that term at the time. Several months ago, I was viewing the Ultimate Fighting Championship with family and someone suggested we bet on the fights. We would pool money and bet on who would win the fight and what round (or decision) they would win in The gamble was, on the surface zero-sum. No one was taking a cut of the bets. And I did research. I immediately pulled out my smartphone and looked up the favorite in each fight. I then looked up what percentage of UFC fights end by knockout versus decision. (click to enlarge) 41% of fights go to decision. Assuming a three round fight (most fights are 3 rounds, championship fights are 5), that 41% is significantly higher than the 25% it would be if each outcome were equally likely. So in each fight, I picked the favorite by decision with some confidence that I had a positive expected value. I won three out of the four fights we bet on. My approach to these situations where the game is explicitly zero or positive sum is in stark contrast to negative expected value situations. Casinos take a cut of all bets by structuring games such that odds are slightly in their favor. The lottery usually has a very negative expected value because: the winnings are taxed at the highest federal income rate and by your state as well municipalities take a huge cut (it’s a significant source of revenue for them) the advertised prize is not a present value, it’s usually a long-term annuity – taking the cash up front means getting far less there could be multiple winners that split the winnings, and the probability of this increases when the pot is large and many tickets are sold, offsetting the EV benefit of the higher pot. I’ve never engaged in these sorts of activities and would have a lot of trouble forcing myself to. It is counter to the investor mindset. But short sellers do just this. On average, they will lose money. The expected value is negative. The idea, though, is that by doing deep enough research and being opportunistic enough, they can make the expected value positive. This is tough for me to accept. First, the odds are dramatically against them on the surface. If stocks appreciate 9.5-10% a year in nominal terms, those odds are far worse for the short seller than some casino games. For example, in blackjack, the odds of you winning versus the dealer are 48%. Roulette is something like 47.4%. If stocks are appreciating 9.5-10% that’s the equivalent of ~45%. And that’s just the direct costs. Then there’s taxes, dividends you must pay on the shares you short, borrowing costs on hard to borrow stocks (unfortunately, many of the stocks with the best short cases have the highest borrowing costs because everyone wants to short them). This is somewhat offset by the fact that you can (I believe) use some of the cash you receive from the sale upfront for other things in the interim. I believe this depends on your creditworthiness as perceived by your broker, the size of the short sale relative to your assets, etc. Some brokers may require you to keep the margin in cash, which eliminates this benefit. The bottom-line: short selling is a negative expected value activity, so why do it? What are you optimizing? Value Investors Club is a great site. The quality of research is very high and there are some smart people on it – some of the smartest people in the investment industry, in fact. That’s why it confounds me that some of these investors are so short-focused. Some of these investors have written 25 articles and like 23 of them are shorts. Some of the smartest investors with the highest profiles are also heavy shorters. David Einhorn and Bill Ackman come to mind. Ackman now describes his firm as primarily long but opportunistically short, which may be the case, but historically he’s done a lot of shorting. I have a theory that these investors are attracted to shorting precisely because the expected value is worse than going long. It’s harder. It requires deeper research. It’s intellectually stimulating. It’s exhilarating. These things probably really appeal to smart people with a chip on their shoulders for some reason. But what is investing about? Is the goal of investing to optimize return or optimize intellectual stimulation? Most investors agree verbally that it’s all about return, but most don’t behave that way – and there are other examples. Obsessions over volatility, dividends, minimizing taxes, etc. are all examples of other things I’ve found many investors trying to optimize through their behavior. Buffett has said a few insightful things on this topic: “You don’t get points for difficulty” The mono-linked chain metaphor The one-foot hurdle metaphor It is certainly understandable that for investors capable of analyzing and understanding very difficult situations, it is challenging to focus on easy ones. Conclusions I have some other thoughts like the idea of specialization – maybe an investor, for some reason like a deep skeptical streak, is much better at shorting than going long – but they will have to wait for another post. This article is just me putting my thoughts to paper. At this point, I’m comfortable recommending that most investors (including myself) focus on positive expected value situations to optimize return and that means avoiding short selling.