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Commentary

Discipline through Shorting

I admire Elon Musk. I believe he is one of the greatest Entrepreneurs of the 21st Century, no doubt about that. Yet, he can be devastatingly wrong – for like when he recently railed against Shorts and called them to be made Illegal.

Shorts for all their claims and prophecies aren’t gods descended from heaven who have the ability to make or break companies. While they do push those companies on the edge to the other side, the companies that aren’t so precariously positioned have been able to devastate the careers of more than one such bear.

In India, shorting stocks other than those in the Futures and Options list is next to impossible. There is no easy way to borrow stocks to sell short with the intention of covering later. Yet, way back when derivative market in India was well in its infancy, it was Shorts who short circuited the market and the career of Ketan Parekh and his friends.

Mathematician Carl Jacobi came up with the term “Invert, always Invert” but it was Charlie Munger who popularized the same when it comes to the market. At its root lies the thought that if you are bullish on a stock, you should also be able to argue on the bearish side for this shows that not only have you worked on the positive side but also have the understanding of the risks that the investment can bring forth.

New age bulls while chanting the mantra’s of Warren and Charlie though seem to have forgotten that it’s more than just a theory, it’s the reality. Not surprisingly, as markets kept seeking lower lows, we have had bulls railing against everyone who they believe are responsible for the current situation – the government to RBI to Media to those who Short.

The other day, a recently famous option expert commented that Put option buyers want India to be destroyed just because they want to make some money. Not very different from saying that Life Insurance policies are being bought to bankrupt the Insurance company.

Shorting is not a piece of cake for even the most accomplished of fund managers – Jim Chanos the supposed King of Short Selling was revealed in a recent long form article that appeared in the Institutional Investor to have lost around 0.7% in his Short only fund since Inception which was in 1985.

Yet, his long short fund has generated a net annualized gain of 28.6% since launch in October 1985, more than double the S&P 500. As a fellow hedge fund manager commented, if the numbers are true, “It’s one of the greatest records ever”.

As investors, we abhor the short side. The long side gives us plenty of comfort since we know that the worst we can lose is only our capital already employed in the trade. A short on the other hand can lose an unlimited sum for a stock can theoretically go to Infinity and beyond.

Its isn’t easy for the small investor to create a Long Short model either for the capital requirements for a short are much higher and demanding. But the shorts don’t just demand money – they demand attention and continuously question our beliefs and methods.

We are optimists by nature and yet when the market turns against us, we become the worst pessimist – from wondering whether we went wrong to whether the whole world was loaded against us.

In markets, most of us aren’t optimists in the first place and therein lies the problem. We are at best opportunists who think we can piggy back on the market for some easy money. But when thing goes south, we find ourselves wondering if optimism is over-rated. Technical Analysis works on the fact that human psychology doesn’t change & every cycle proves the same.

Investors these days are better informed than those of us who started out in the pre-internet era. They have a better understanding of allocation, behaviour biases, market psychology among others and yet, I find them not immune to excesses and when things go sour, most seem to follow the path of those who haven’t studied history or human behaviour or cycles – rail against the system first and throw the towel at the worst possible time.

As much as it’s important to read more – especially financial history and human psychology, I am beginning to believe that portfolio construct needs to form the basic foundation. A good portfolio needn’t be made up of longs only for shorts do have their own space.

One doesn’t need to have a short position as big as the long position, but even a small short position keeps the investor on his toes and asks him to take the tough calls. A short challenges ideas and views like no longs can ever do.

The other day, I heard Safir Anand claim that 90% of investors lose money – by lose money I don’t think he meant that they actually lose money but many lose by missing out on opportunities or missing out on getting market returns.

But in the age of everyone being above average, it wouldn’t be surprising if the percentage of investors who despite the best efforts not just underperformed the markets but actually lost money by buying high and selling low – the exact opposite of what they wanted to achieve is 80% or so {Pareto Principle}.

I incidentally run a Long Short Portfolio on my personal books – the short position being placed not by way of understanding, intent or thought but by accident. Yet, when markets were booming and the short was losing money, it kept me thinking about the range of possibilities and where and how far I could go wrong and the likely remedies for soothing the pain.

While the initial thought was to close out the short as soon as got back to my Anchor bias level, deeper or 2nd line of thinking now seems to suggest to me that shorts can be a very effective instrument against one’s own biases going off tangent.

As Jim Chanos has experienced, the shorts may not actually make money for you but can be an efficient risk management tool that helps manage your Risk at a level that ensures survival in the deepest of bear markets.

Shorting is Risky, no doubts about that – yet, Investors, many of whom are down 40 to 50% in the current down cycle didn’t really anticipate such risks when they came into the market. We accept risk ex-post, why not accept it ex-ante.

 

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