Ask Colin

Why do you not short the market yourself?

There are several reasons:

The first reason is that stock markets are traded in nominal dollar values, not real dollar values. This means that there is a long term upward bias to prices based on the fact that inflation continues to reduce the dollar value of assets, hence prices must rise. This means that investing in stocks by buying rather than short selling is trading in the direction of the long term trend. A quick look at any long term chart of Australian, US or UK stock market indices will show that the chart basically runs from the lower left corner towards the upper right corner. Of course, this is less true the shorter the time frame we trade, which is where other factors come in.

The second reason is quite a personal one. I have found over a long time that I am a naturally optimistic person. This makes it difficult for me to bet on failure. I am much more comfortable backing success. This may sound like a very ephemeral thing, but the longer I live and work in markets the more I respect the need to trade in harmony with our belief system.

The third reason is that I have found it difficult to re-orient my thinking to trading the short side. It seems to me that to be successful, we need to develop a trading or investment style that we can hone to the point where it almost becomes instinctive. We achieve mastery at the point where when something happens, we know what to do immediately and without question. To achieve this level we need to specialise. This is not to say that someone else may be able to deal with both sides of the market and I would be silly to try to deny that possibility. Perhaps if I tried harder, I too could do it. Maybe I will, I always reserve the right to continue to improve what I do.

The fourth reason is that there is greater complication and expense in short selling. Complicated things are implicitly dangerous in the markets, because unusual situations do happen and can bring us undone. However, it is the cost that worries me more. One of the greatest bars to succeeding as a trader is the friction costs - brokerage and slippage. The more you trade the less likely you are to succeed, because of these costs. Most brokers charge more for short selling - you need to do it on the phone rather than use the cheaper Internet systems for a start. Slippage also tends to be higher because of the up-tick rule.

The final reason is one that I used to not worry over much about, but for which I now have a greater respect. That is the prospect that short selling can involve unlimited risk. There is an excellent discussion of this in Jack Schwager's book Stock Market Wizards in the part in the back of the book where he draws lessons from the interviews. The danger he highlights comes from takeovers. Takeovers are quite likely to occur in the stocks that are sold down strongly by the market because they become very cheap. Combine a takeover with a trading halt and you have a very nasty experience. It can be argued, as I used to, that takeovers are a fairly rare risk. That is true. However, it is these sort of rare events that can destroy a trading account. The Nobel laureates at Long Term Capital found this out to their cost when Russia devalued the Rouble and defaulted on debt.