Short selling a stock is a 'foolish risk' for the average investor, says CFP: Here's why

When you short sell a stock, you're betting the company's share price will fall.

Scott Mlyn | CNBC

Shares of the video game retailer GameStop made a meteoric rise in January, surging 1,625%. The stock gave up some of those gains this week, falling by 72% as of Wednesday afternoon. Despite the sell-off, the stock's short-term momentum led to very big losses for some hedge funds.

GameStop has been the target of a stock trading technique known as short selling. Investors borrow shares of a stock to sell them at a certain price, expecting that the market value will be less than that when it's time for them to pay for the borrowed shares.

That shifts the investor's goal. Typically, when someone buys a stock, they're betting the company's share price will go higher. "Short selling is the opposite of buying for gains. You're buying hoping that the stock does badly," explains Carolyn McClanahan, a certified financial planner and the director of financial planning at Life Planning Partners in Jacksonville, Florida.

It's not a tactic average investors should use, McClanahan adds: "Short selling is a foolish risk."

Here's what you need to know about short selling, according to experts, and why McClanahan calls it a "losing game" for the average investor.

How the GameStop saga highlights the risks of short selling

Short-sellers have lost a collective $5 billion this year betting against GameStop as of Wednesday afternoon, according to data from the financial analytics firm S3 Partners.

How it happened: Large professional investing firms have been expecting GameStop's value to decline as video game sales move online and away from brick-and-mortar stores. So they took positions shorting the stock.

But then individual investors — who, unlike institutional investors, use their own cash to trade stocks — bet against those GameStop short-sellers. Those average investors have taken to the social media platform Reddit to encourage the buying of GameStop's shares, pushing the stock's price higher and generating losses among short-sellers who were forced to buy higher-priced shares to cover their positions. GameStop investors who bet on the stock rising have realized enormous gains.

Wednesday, retail investors began using the same tactic (known as a "short squeeze") to push shares of AMC Entertainment higher. The movie theater chain has also been a target of short-sellers.

'Short selling is basically another form of gambling'

The process of short selling is a bit more complicated than betting against a company, explains Michael Santoli, CNBC's senior markets commentator. "An investor who expects a stock to fall can 'sell it short' by borrowing shares from a broker and then selling them, in hopes of buying them back at a lower price, profiting from the price difference," he says.

Since short selling means you're "borrowing a stock," you don't really own it. That's what makes short selling so risky, McClanahan says.

When you own a stock, the worst case scenario is the stock price goes to zero and you lose the amount of money you paid to buy those shares, Santoli says. "An investor who shorts must pay interest on the borrowed shares, put up collateral with a broker against this loan, and might have to give the shares back on short notice if the owner or broker asks," he says.

The losses on a short sale can be astronomical. "Potential losses are theoretically unlimited. A stock price can keep rising infinitely, to multiples of the price at which the shares were sold short," he says.

For the average investor, "short selling is basically another form of gambling," McClanahan warns.

'Short selling is largely done by professional investors'

If short selling is so risky, you may be wondering why it exists as a practice at all. "Shorting is largely done by professional investors, especially those at hedge funds, which by definition often take a combination of bullish and bearish positions on investments," Santoli says.

Professional investors use this tactic for a few reasons. "Shorting is a way of acting on what an investor views as an overvalued stock, often of a company seen as having a declining or flawed business," Santoli says.

Short selling is the opposite of buying for gains. You're buying hoping that the stock does badly.
Carolyn McClanahan
director of financial planning at Life Planning Partners

In addition, shorting can help hedge an investment firm's bets. "A fund manager might own shares of a company it believes is doing well and short a competing company in the same industry. This way the investor is looking to benefit from potential outperformance of the 'better' company, while limiting overall exposure to broad market risk," he says.

Besides having a lot of money to play with, professional investors are better equipped to short sell, McClanahan says. "Their job is to know information [about companies]. They pay a lot of money for research. So, if anybody has a shot at it, it's an institutional investor, not an individual investor," she says.

The plethora of stock information online and easy access to stock trading has given average investors a false sense of ability, McClanahan says. "For somebody who's just a regular investor trying to save for their future, you shouldn't be spending your time trying to beat professionals when it's highly likely you're going to lose that game," she says.

For average investors, a winning strategy can be a simple one: Take a long-term and diversified approach, says Noah Kerner, the CEO of Acorns. "As long as you keep your money in a diversified portfolio and stay patient and keep contributing to it, your money — based on all historical precedents — will grow."

"The way to get rich is to get rich slow," says Kerner. "Work hard, invest early, invest often, stay committed, focus on the power of diversification and compounding [interest]; the basic principles of investing."

Potential losses are theoretically unlimited.
Michael Santoli
CNBC's senior markets commentator

'Individual investors shouldn't be doing a lot of trading'

McClanahan's own experience short selling is what prompted her to switch careers and become a certified financial planner. In 1999, while working as an emergency room doctor, McClanahan lost around $20,000 after shorting an internet stock during the dotcom bubble. "I got into day trading stocks because I thought, 'Oh, gosh, I'm smart. I can figure this out,'" she recalls.

The experience was terrifying. "I was like, 'Wow, it's way less stressful taking care of people dying of heart attacks than doing this.' So I never did it again," she says.

Why Warren Buffett prefers passive investing

Video by Courtney Stith

If you've already shorted a stock and are losing money, "get out while you still can," McClanahan says. "If you lost $10,000 and you can't afford to lose more, you just have to close that position. Too often people say, 'Oh, it can't go up anymore,' and it does. You could go bankrupt being a short-seller."

Take a more thoughtful approach to investing for your future, McClanahan suggests. "The regular person, the individual investor, shouldn't be doing a lot of trading."

Instead, she recommends following the advice of legendary investor Warren Buffett, who said, "Your best bet is plunking your money down in an index fund and letting it go."

Grow is produced in partnership with Acorns and CNBC.

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