Why shouldn't you short sell stocks casually? This is not a simple game of gambling; it's staking your entire fortune on human nature

There must have been situations like this around you:

Your brother noticed a certain speculative stock skyrocketing wildly. He thought that the bubble would burst someday, so he borrowed money to short sell it. As a result, the stock price rose by another 30%. He was forced to close out his position by the brokerage firm. Not only did he lose all his principal, but he also ended up owing 200,000 yuan.

Another person invested in a hot pot restaurant. Even if the business didn’t go well, at most he would lose 500,000 yuan of his principal. However, if he shorted futures and the market trend went against him, he might end up losing 1 million yuan - this is the most terrifying aspect of short selling: it’s a gamble where the potential profit has an upper limit, but the potential loss is limitless.

Buffett once said harshly, “Charlie and I have had hundreds of thoughts about short selling in our lives, but if we had actually done it, we’d most likely be penniless now.”

Why do even the stock market gurus stay away from short selling? Today, let’s take a look at where the risks of short selling are hidden.

Short Selling VS Going Long: An Unfair Contest Right from the Starting Line

Profit: Going long is like climbing stairs, while short selling is like jumping off a cliff.

• The Infinite Possibilities of Going Long:

You invest 100,000 yuan in your friend’s milk tea shop. As long as the brand expands successfully, it’s possible to earn 500,000 yuan or even 1 million yuan in three years - the profit potential has no ceiling. This is the most fascinating compound interest magic in the capital market.

Just like Amazon, which has increased by 200 times since its listing 20 years ago. Early investors achieved financial freedom by going long.

• The Fatal Ceiling of Short Selling:

Suppose you borrow 100 shares of Stock A (with a share price of 100 yuan) and sell them all, getting 10,000 yuan. Even if the share price drops to 1 yuan, you can at most earn 9,900 yuan (a return rate of 99%). But if the share price rises to 200 yuan, you’ll have to spend 20,000 yuan to buy back the shares, suffering a 100% loss. If it rises to 500 yuan, the loss will be 400% - the loss “explodes geometrically” as the share price increases.

Just like in 2020, when GameStop was wildly hyped by retail investors banding together, the short selling institution Citron Research suffered a single-day loss of 30% and was eventually forced to liquidate its position.

Loss: Going long may lead to losing all the principal, while short selling may lead to owing money.

The Risk of Going Long is Limited:

Even if the stock you bought is delisted, at most you’ll lose 100% of your principal (for example, the investors of LeEco).

The Risk of Short Selling is Unlimited:

In 2018, an investor shorted NIO. At that time, the share price was 3 US dollars, and he believed that “new energy vehicles are all scams.” As a result, NIO’s share price rose to 66 US dollars in 2021, and his loss was more than 20 times - it’s equivalent to short selling with a principal of 1 million yuan and finally having to pay 20 million yuan in compensation.

In a nutshell: Going long means taking limited risks for unlimited returns, while short selling means taking unlimited risks for limited returns - in terms of mathematical expectation, short selling already loses at the starting line.

Buffett’s Warning: The Biggest Risk of Short Selling Isn’t the Numbers, but Human Nature

You can never predict how big the bubble can get.

The Trap of Human Nature: There’s Always a “Higher Overvaluation” After “Overvaluation”

The market is like a drunk driver. You know that he will crash sooner or later, but you don’t know whether he’ll run a red light or drive in the wrong direction first.

In 2021, Tesla’s price-to-earnings ratio exceeded 1,000 times. The short sellers were shouting that “the share price is overvalued by 500%,” but a single tweet from Musk could make the share price rise by another 20%. In a market driven by emotions, it always eliminates the short sellers one step ahead of rationality.

Short selling is gambling on your own patience with borrowed money.

The Pain of Cost: Interest is like a blunt knife.

Short selling requires borrowing stocks from a brokerage firm and paying an interest rate of 0.1% - 0.5% per day. If you short sell stocks with a market value of 1 million yuan, the annual interest will be between 150,000 and 500,000 yuan. As long as the share price remains sideways for half a year, the interest can eat up 30% of your principal.

In 2019, a certain private equity institution shorted Kweichow Moutai. Due to the long-term fluctuation of the share price, it lost 20 million yuan just in interest and was finally forced to cut its losses.

Psychological Torment: Watching the loss in your account is even more painful than cutting your losses.

When you’re stuck in a losing position while going long, you can comfort yourself by holding the stock for the long term. But when the share price rises after you short sell, you’ll be torn between whether to cut your losses or not:

• Don’t cut your losses? Your account shrinks every day, and you can’t sleep at night.
• Cut your losses? It’s psychologically difficult to admit that you made a wrong judgment.

This kind of agonizing pain is more terrifying than a margin call - it will slowly destroy your investment mentality and make you go further and further astray in the market.

The Three Fatal Weaknesses of Short Selling: Traps That Even Professional Investors Can’t Avoid

The Reverse Trap of Value Investing: What You Think Is Overvaluation May Be Reasonable in the Market

In 2017, Muddy Waters shorted China Huishan Dairy and accused it of inflating its assets. But after the short selling report was released, the share price actually rose by 10%, and it didn’t suddenly plummet until three months later.

This reveals a truth: The market’s tolerance for overvaluation far exceeds the imagination of value investors.

Many growth stocks (such as Contemporary Amperex Technology Co., Ltd. and BYD Company Limited) have maintained a high price-to-earnings ratio for a long time because the market believes that future growth can justify the valuation. If short sellers only look at the P/E ratio and not at the industry trend, they are easily dragged down by the “time cost.”

The “Professional Barrier” of Short Selling Institutions: Retail Investors Simply Can’t Afford to Play

Muddy Waters’ Three-step Approach to Short Selling Luckin Coffee

① On-site Research: Sent 1,500 employees to 45 cities and recorded the customer flow of 2,213 stores.

② Data Verification: Analyzed the number of vehicles in the parking lot through satellite images and compared it with the financial report data.

③ Legal Litigation: Joined forces with more than 20 institutions to launch a class action lawsuit, forcing Luckin to admit to fraud.

This level of research requires tens of millions of funds and a professional team. For ordinary retail investors to short sell just because they feel the stock is overvalued is like going to the battlefield with a kitchen knife.

The “Meat Grinder for Shorts” of Policies and Regulations

The Double Strangulation of “T+0” and “Price Limit”

In the US stock market, the brokerage firm can recall the stocks you borrowed at any time and force you to close out your position (for example, during the GameStop incident in 2020, Robinhood suddenly closed the short selling channel).

These rules mean that short sellers not only have to contend with the market but also with the makers of the game rules.

Buffett’s “Three No Principles for Short Selling”: A Lifesaver for Ordinary Investors

Don’t Earn Money from a Zero-sum Game

Going long means growing together with the enterprise, and you earn money from the company’s performance growth.

Short selling means hoping for others to go bankrupt, and you earn money from the losses of other investors. The former is a “win-win” situation, while the latter is a “life-or-death” struggle.

Buffett said, “I never want to see others have bad luck, even my opponents. This kind of mentality will make you lose your rationality and make wrong judgments.”

Don’t Touch the Leverage You Don’t Understand

Short selling is essentially a reverse operation of leveraging. Even if you make the right judgment, you may still fail before success:

• Before the Great Depression in 1929, the economist Irving Fisher accurately predicted the stock market bubble, but because he shorted in advance, he went bankrupt before the crash.
• During the 2008 financial crisis, Michael Burry, the prototype of the big short, laid out his plan five years in advance, but due to the pressure of investors redeeming their investments, he almost failed.

Don’t Challenge the Weaknesses of Human Nature

Short selling requires overcoming two anti-human operations:

• Going against the trend: When 90% of the people in the market are bullish, you have to firmly believe that you’re right.
• Cutting your losses in a timely manner: When the loss exceeds 50%, you can decisively cut your losses and exit the market.

Even professional investors find it difficult to possess these two abilities, let alone ordinary retail investors.

A Word to Novices: If You Really Want to Short Sell, Ask Yourself Three Questions First

Can Your Principal Withstand a “Loss of 200%”?

Suppose you have 1 million yuan. After short selling, if the share price rises by 100%, you need to add 1 million yuan in margin. If it rises by 200%, you need to add 2 million yuan. Do you have enough funds and the psychological preparedness to face this bottomless loss?

Can You Withstand the Pressure of “Not Making Money for Three Years”?

Even if you make the right judgment, the share price may take 3 to 5 years to drop (for example, the investors who shorted Kweichow Moutai in 2015 didn’t wait for the pullback until 2018 and experienced two major rallies in the middle).

Do you have a stable source of income to support you through the long wait?

Are You More Professional Than Muddy Waters and Citron Research?

If you don’t have a team for research, data verification, and legal support, and you short sell just because of “abnormal financial statements,” your success rate is comparable to “winning the lottery jackpot.”

Investment Is Not a Game of Gambling on Odds, but Rolling a Snowball

Returning to the question at the beginning: Why shouldn’t you short sell?

• Mathematically, it’s a game with limited returns and unlimited risks, and it has a negative expected value.
• In terms of human nature, it tests not your wisdom but your self-control against human nature.
• In reality, it’s a meat grinder for professional institutions and, even more so, a graveyard for retail investors.

Buffett’s partner, Munger, once said, “If the thing you shorted keeps rising due to some semi-deceptive speculation, you keep losing money, and they also ask you to add more margin - this kind of trouble is simply not worth having in your life. It’s easier to make money elsewhere and with fewer troubles.”

True investment should be like rolling a snowball - finding a long slope (a good market segment) and wet snow (a good company), and patiently waiting for the snowball to roll bigger and bigger.

It’s better to plant a big tree on the plain than to pick gold coins at the crater of a volcano. This is the investment path that ordinary people should take.

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Extended Thinking: How to Deal with an “Overvalued” Market?

If you think a certain stock is too expensive, the correct approach is not to short sell but:

① Wait for the pullback (set a conditional order to automatically buy when it drops to your psychological price).

② Look for undervalued targets in the same market segment (for example, when liquor stocks were overvalued in 2021, invest in beer stocks at a low price).

③ Allocate inflation-resistant assets (such as gold, REITs) to hedge against market bubbles.

The essence of investment is to fight against “greed” with “rationality,” rather than fighting against “greed” with “greed.” Remember: Not short selling is the first line of defense to protect your principal.