At my previous firm I watched time and again as short ETFs and mutual funds led to incalculable losses for client accounts. Based on my own informal analysis of these trades, I calculated that 8 out of 10 times we lost money being short. In addition, the very few times that we did make money the gains were so minimal as to be almost laughable given the risk involved.
Now don't get me wrong, I am not one to buy and hold stocks forever. In fact I believe that risks must be managed and that at certain times a very small short position can hedge off a large core holding or highly appreciated gain. What I am talking about here is being net short the market, i.e. cash, bonds and short positions are your only holdings. Let me set the scene for you so that you visualize what a truly bearish mindset can do to damage your portfolio.
You wake up one day and decide that the "top is in." There is no possible way that stocks could go any higher from here based on every fact you know about the economy, politics, global events and how much money all your friends are making on Apple Inc. (APPL) stock. So you decide to sell everything (or maybe you did not own any long positions to begin with) and today you are going to go short.
The next few days pass and the market recedes 2% to 3% and you are elated with your own sense of perfect timing and intuitive decision making. But you wake up on the third day and all of a sudden stocks are up 2%. By the end of the week stocks are up 5% and you are already in the red in your newly established short position. But not to worry, there is always next week, and there is no possible way the market could go any higher from here.
Week after week the market continues to march higher - payrolls were better than expected, corporate earnings are all topping estimates, GDP is above consensus, and the Fed Chairman is doing everything he can to keep interest rates low. The list goes on and on while your hard earned money evaporates day after day.
You throw out the rules on stop losses and risk management because there is no possible way given the state of the world that the market could keep going higher from here. But it does. Your losses keep mounting and you wake up every single day hoping for a war, natural disaster, or horrific event that will tank the markets. But it never comes and you wallow in despair and negativity not because you made the wrong investment decision, but because the rest of the world just "does not see what I see".
One of the best mantras I have ever heard and will always remember is that "the stock market is not logical, it is psychological." What this means is that it will continue to defy belief and climb a wall of worry despite factors that would seem to be contrary to growth and expansion. When you are short the market you are fighting the entire system. You are fighting the Fed, you are fighting the banks, and you are fighting your friends and neighbors' retirement accounts. It's like the equivalent of a bicycle trying to stop a moving freight train. In almost every instance you will get run over.
Wouldn't a more sound investment philosophy be just to move your portfolio to cash and wait for a better buying opportunity if you feel that the market is overbought? Then if the market does move higher the only thing that you have lost is opportunity and not real money. Another strategy would be to keep your long positions and hedge them off with a very small allocation to a short fund. That way you are still participating in the upside of your existing positions but don't have the same amount of risk on the downside (advanced investors can use options to accomplish the same thing).
These are just two strategies that may work well in a declining market environment, but there are also countless others that can be implemented for savvy investors that are concerned with risk management.
About the author:
David’s responsibilities include: operations management, technology coordinator, chief compliance officer, investment research, client communication, marketing and portfolio management. In addition, David actively contributes to the Fabian Capital Management blog, podcasts, and special reports.