Steer Clear of Trading on the Short Side

Baccarat and blackjack are two casino table games that offer the best odds in the house. Nonetheless, on average, you'll lose 1% to 2% of your money each time you make an optimal bet.

Compare that to making a single bet on the NYSE Composite Index. On average, for each year that you keep your money invested, you'll make 8% to 10%. Why, then, do folks engage in the practice of shorting stocks? They've effectively placed a bet where, off the bat, the odds are about 8% to 10% against them.

When you look carefully at the economics of shorting, it makes no sense to take the bet. The lowest price a company's stock can go to is zero, but there's unlimited upside. An unleveraged short position has a maximum payoff of 2-to-1. That is, you'll double your money if the company's stock price goes to zero. On the other hand, the potential for loss is uncapped and infinite. Why take a bet where the upside is a 100% return at most and the downside is going bankrupt?

Because there's no limit on how high or how fast a company's stock price can rise, anyone who shorts even a single share of stock can never stop watching the tape. Odds are very high that I'll go to my grave without ever having shorted a stock. My quality of life would go down dramatically if I were forced to watch every wiggle in the market. Sometimes, while on vacation in some remote corner of the world with no access to even week-old stock prices, I don't have to worry about my 100% long unleveraged portfolio, with 8% to 10% long-term odds in my favor.

The Overvaluation Argument

I routinely hear very convincing arguments that certain companies are ridiculously overvalued and that it's painfully obvious that the only thing that can happen to them is a share-price decline. Indeed, when a cheapskate like me looks for stocks to buy, I always find most of them trading at lofty prices that cannot be justified.

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Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.