Page 2 of 2 SPEAKING
FREELY How to save your skin and
profit By Doug Wakefield
making a profit from declining
prices. Expecting a drop in price, we sell the
stock, and buy it back later at a lower price. The
difference is our profit.
The natural
question is: How can you sell a stock that you do
not own? When you sell a stock short, the broker
lends you the shares from a buyer, who previously
approved such an
arrangement. Later, when you
buy the stock back (otherwise called covering),
the broker returns the shares to the buyer, and
all is settled.
For example, you believe
XYZ Corporation stock price is too high, so you
instruct your broker to sell short 100 shares at
$50. The broker borrows 100 shares from another
account and "delivers" them to you, the
short-seller. As a short-seller, you immediately
sell the borrowed 100 shares at $50 per share, and
$5,000, the proceeds from the sale, is credited to
your account. If the stock were to fall to $30 a
share, you might then decide to buy the 100 shares
you borrowed back for a total of $3,000. You
return the borrowed shares to the broker, and you
make a $2,000 profit.
Of course the stock
may go up instead of down. Suppose it goes to $60,
and you decide to purchase in order to minimize
your losses. You buy the shares back, and you have
lost $1,000. The net result is not all that
different from a situation where you had bought
the stock at $60 and watched it decline to $50.
Unless the broker "calls" the stock back
because he must return the borrowed shares to the
owner for some reason, there is no limit on the
amount of time you may remain short. But having a
stock called away is a highly unusual situation
which usually only occurs with stocks that have a
low level of liquidity. There are a few stocks
that the broker cannot obtain, and in such cases,
you may not short that particular stock.
There are only a very few pure
short-sellers, probably measured in the single
digits, versus many thousands of mutual funds and
hedge funds. In my opinion, this endeavor requires
a special aptitude, which is not easily
transferable from the long side (without
considerable experience).
Doug: How does the client
benefit?
Bob: The same way
one benefits if a stock rises. Most investors buy
stocks hoping they will increase. The short-seller
makes a profit when the stock declines. When an
overvalued market turns down, by definition most
stocks decline, and portfolios that are short,
increase in value. So, not only does the client
not lose money, but by implementing this "hedging"
strategy, he or she actually profits. Typically,
as a measure of diversification, short-selling is
only done with a portion of a client's total
assets.
Doug: Bob, I'd just
like to thank you for taking the time to share
your experience and knowledge with us today.
The psychology of
denial Unfortunately, millions of investors
will never heed the words of Bob Lang or an
article like this one. They continue to see
warnings in their everyday lives, but take comfort
in the fact that their friends and advisers are
all doing the same thing. They ignore reality and
trust theories that have worked well (for the past
three decades) in an ever-expanding sea of credit.
So why do most individuals, maybe even those
reading this article, never take steps to protect
their capital from a bear market?
In
answering this question, I turn to a professor of
geology at the University of California, Los
Angeles. As an evolutionary biologist,
bio-geographer, and Pulitzer Prize-winning author,
Dr Jared Diamond addresses the "it can't break"
mindset in a story about individuals who live
below a dam.
According to Diamond,
attitude pollsters ask people who live downstream
from the dam how concerned they are about the
possibility of the dam bursting. Naturally, those
who live further away from the dam are less
concerned about it breaking than those who live
closer to it. But shockingly, from a few
kilometers below the dam, where one would assume
the fear would be the greatest, as we approach the
dam, the concern about the dam breaking falls off
to zero.
Why? Diamond notes that those
living closest to the dam, who are sure to drown
if the dam breaks, must make themselves believe
that the dam couldn't break to preserve their own
sanity. This ability to suppress or deny thoughts
that cause us great pain is known as psychological
denial. Diamond suggests that this behavior,
common to individuals, could apply to groups as
well.
The only way investors will be able
to take constructive financial steps before this
credit cycle contracts is to step outside of the
powerful forces of the herd. From here, they can
begin to address the unpleasant reality of that
which is currently unfolding and how we got here.
Denial will only lead to unnecessary losses and
increased pain.
Doug Wakefield
is president of Best Minds Inc, a registered
investment adviser. Disclaimer: Best Minds Inc has
clients who are using the investment management
services of Lang Asset Management.
(Copyright 2005-07 Best Minds Inc.)
Speaking Freely is an Asia Times
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