Tuesday, 11 May 2010

Investing mistakes I’ve made – shorting the stock market

As I’ve travelled down my chosen road of taking full responsibility for my retirement investing strategy I’ve made plenty of mistakes that have cost me money (and I’m sure I’ll make plenty more). I’d therefore like to share some of these with you over the coming months. Previously I covered contango & exchange traded commodities (ETC’s) and today I’m going to cover shorting the stock market.

For those that aren’t regulars of Retirement Investing Today (although if you’re not there is plenty of good quality history to be found in the right hand side bars) I’m working towards retirement in a little less than 7 years from today following which my investments will have to last me the rest of my life. That definitely makes my strategy long term and I believe it is that of an investor rather than a trader.

Let’s start with what is shorting ? Wikipedia gives quite a nice description which includes “the short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase ... Conversely, the short seller will incur a loss if the price of the assets rises.” So where did I go wrong?

The first mistake I made was to forget the common mantra that it is ‘time in the market’ not ‘timing the market’. I spent hours on the internet conducting all sorts of research and following all sorts of guidance from short term indicators which made me think that the market was ready to go all bearish and take a tumble. Who was I kidding? I am a full time employee who doesn’t work in finance. How did I expect to be able to beat professional traders? I have about as much chance of timing the market as I do of winning Olympic gold. So for me I know longer will try and time the market.

Secondly I selectively forgot the classic quote from John Maynard Keynes which is that ‘the market can remain irrational longer than you can remain solvent’. Imagine that it is August 1997 and you are doing your research and comparing historic cyclically adjusted PE (CAPE) valuations of the S&P 500. You know all your history and compare the CAPE of 1929 (just prior to the great crash and subsequent great depression) with what you see today and realise that you are at about the same CAPE valuations. So you go short at an S&P 500 price of 927 thinking the market is over valued and about to take a tumble. What happens next? Well we all know the story, the market continues to rise to 1485 or so over the next 3 years which would have wiped you out.

Thirdly I forgot that the stock market naturally rises in price over long periods for numerous reasons. To have the S&P 500 back at its real (inflation adjusted) price of January 1871 the price today would have to be around 78 but with short selling inflation is not considered and so the price would have to fall to 4. Not likely is it?

Fourthly governments around the world will never let markets operate freely and will always cause distortions. This is best explained with a recent example. Imagine that you saw the bond disaster unfolding in Greece and other parts of Europe and so you decide to short some European Stock Indices. You are then feeling quite comfortable reading all the Black Monday predictions over the weekend. You then head off to work early Monday morning and at lunch time have a quick look at the stock market to see how much you’ve made and find this has occurred.

So in my opinion short selling is a trader’s tool and not an investor’s tool. So I’m out from here on in. I have come to this conclusion before I even contemplate the issues/limitations associated with various short selling techniques such as inverse ETF’s, puts or just plain old stock shorting.

As always do your own research.

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