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Your Money: Without short-selling, one would only look for stocks that rise

Without short-selling, the general tendency if for everyone to look for stocks that will rise and just ignore the ones they think are overpriced, writes Dhirendra Kumar.

india Updated: Nov 18, 2007 20:58 IST

A couple of days ago, SEBI announced that it would allow mutual funds to do short-selling. Short-selling has always been a much-maligned and poorly understood activity among many investors. A certain type of investor always tries to explain away his losses by blaming short-selling, the implication being that the poor guy bought a great stock but short-sellers ruined it all.

To be fair, this wasn't always an exaggeration. In the cowboy era of the Indian stock markets, there were some fairly plausible stories about notorious short-sellers holding promoters to ransom by shorting their stock. It is said that sometimes such activity was literally for ransom, meaning the shorting wouldn't stop till the promoter coughed up a few suitcases full of cash. But some promoters managed to turn tables on the shorters, most famously, Dhirubhai Ambani sometime in the 1980s, in an incident that I think is even referred to in the movie Guru.

In fact, the genesis of the Reliance equity cult is supposed to be Dhirubhai's idea that the only way to escape short-sellers was to build an army of retail shareholders as a counterweight. I'm not sure whether this is actually true but the point is that many of us have always believed that short selling is an evil activity. Investor wants stocks to go up and instinctively feel that anyone who wants them to go down must be up to no good.

The dictionary meaning of short selling is to make money from a fall in a stock's price. In simplified terms, if an investor thinks that a stock is overpriced then he sells the stock without owning it. Later, when the price falls, he buys it at the lower price and delivers it to whomever he had originally sold it too. Clearly, like any normal ('long') trade, shorting is also about buying low and selling high, the only difference being that here the selling is done first and the buying later. This enables one to profit from a falling price.

Of course, if the prices rise instead then a short-seller will make losses because he will have to buy at a higher price to deliver the stock. In most stock markets, shorters have to borrow (or make some other arrangements for) the stock they are shorting. It must be noted that short-selling holds the risk for unlimited losses. For example, a short-seller could sell a stock at Rs 100 and if the price later goes down to Rs 85, he could earn Rs 15. Theoretically, at best the price could go down to zero and the shorter could make Rs 100. But if the price starts going up it could go to Rs 200 or 300 or Rs 1000 or whatever, thus losing the shorter any amount of money. In practice, there are loss-control measures at the market and broker level as well as at the level of institutional investors like mutual funds but being short is probably more inherently risky than being long. It is easy to select from a market full of overpriced stocks (as today) and say that this one or that one is bound to fall but as the economist John Maynard Keynes said, "The market can stay irrational longer than youcan stay solvent".

Still, short-selling is a very useful activity. Without short-selling, the general tendency if for everyone to look for stocks that will rise and just ignore the ones they think are overpriced. In today's situation it would be good to have some investment researchers and investors seriously hunting for overpriced stocks and seeking to knock them down.

The writer is CEO, Value Research India Pvt Ltd