Imagine for a second I lend you my car under the agreement you return a replica of it in 30 days. I don’t care if you return the exact vehicle I lent you. The replacement just has to be the same in terms of make, model, mileage, etc.

You then sell my car, intending to buy another one in 30 days. You hope you can find one for less. That way, you make money on the transaction.

That is a short. You anticipate the cost of the car will drop in 30 days, and you look to take advantage of that hunch without having to buy the car in the first place.

Of course, if the car’s price rises in the next 30 days, you lose money as you now have to buy a car for more than you sold the original.

A highly risky strategy and one I’d never recommended for a client.

To be consistently successful, you’d have to know the future – or seek to create it.

When planes hit the World Trade Center (can you believe that was almost 20 years ago?), terrorists shorted airline stock in advance. They knew those companies would likely see their stock drop because the terrorists know what laid ahead. A very sad example, but one that demonstrates the process quite well.

Here’s another: when a large hedge fund decides to short a stock, it seeks to justify that decision by publicly stating why it thinks the company in question is over-valued. It’ll issue research reports and go on network TV in an attempt to influence others. This is one reason why I strongly discourage investors from listening to most investment “experts.” There is often a motive behind their “advice.”

Last month, we saw the tables turn.

A bunch of day traders noticed that one of their favorite companies, GameStop, was being heavily shorted by institutional investors. So, they decided to buy the stock. And buy they did. The stock went from about $20 a share to over $300. This means the companies who borrowed and sold the stock at $20 had to replace it at a much higher price.

Naturally, the hedge funds are crying foul. Hard to see how that’s the case.

What’s all this mean for your portfolio? Well, unless you owned GameStop, probably not a lot.

But it does underline the importance of diversification, something I see so many investors lacking.

It also demonstrates why speculative moves are not investments but gambles.

This is also why we complete a portfolio x-ray with every one of our clients to understand what they own and why they own it.

If you’d like to learn more about this system, schedule an appointment by clicking here or calling 513-563-PLAN (7526).

Regards,
Nikki Earley, CFP®