Short selling

Short selling is a way to profit from an expected fall in an asset’s price: an investor borrows shares, sells them, and hopes to buy them back later for less. Its significance is larger than the individual wager. Because most investors are positioned for prices to rise, short sellers introduce dissenting judgments into markets, helping make collective prices more accurate and reducing the risk that an already-wrong price will become wildly wrong. The practice has repeatedly been treated as suspect, but the book’s central contrast is that the market’s danger lies less in short selling than in its scarcity.

How the Position Works

A conventional investor goes long by buying a stock in the hope that its price will rise. A short seller instead borrows shares and sells them, aiming to repurchase them after a decline and return them to their owner. The difference between the sale price and the lower repurchase price is the short seller’s profit. For example, selling 1,000 shares of General Electric short at $30 would bring in $30,000; if the price fell to $25, buying the shares back would cost $25,000, leaving a $5,000 gain before other costs.

The wager is not simply the mirror image of buying. A long investor’s potential loss is limited by the amount invested, but a short seller’s potential loss is theoretically unlimited if the stock keeps rising. Short selling also runs against the prevailing expectation in a market that, over time, has generally risen. That combination of financial exposure and social opposition helps explain why the practice remains unusual: in a typical year, only about 2 percent of shares on the New York Stock Exchange are shorted.

A Long History of Suspicion

The hostility is older than modern financial regulation. In 1995, Malaysia’s finance ministry proposed mandatory caning for short sellers, casting them as wrongdoers deserving physical punishment. The proposal was extreme, but the suspicion behind it was longstanding. Because short sellers profit when companies’ shares fall, critics see them as seeking advantage from other people’s losses. The short seller’s pessimistic forecast can therefore appear not merely financially contrarian but morally suspect.

Governments and investors had denounced the practice for centuries. England banned short selling in 1733 and did not legalize it again until the mid-nineteenth century, although the prohibition was reportedly evaded. Short selling was also illegal in New York State in the early 1800s. Napoleon called the short seller an enemy of the state. These episodes made a recurring political pattern visible: when falling prices cause alarm, those who bet on the decline are easy to blame.

That pattern returned after the 1929 crash. Short sellers were made national scapegoats for the country’s economic troubles, denounced in the Senate as a major commercial evil and as a cause of the Depression’s length. The New York Stock Exchange discouraged investors from lending shares, since a short sale depends on borrowing them; President Herbert Hoover worried about the damage short sellers might do, and J. Edgar Hoover considered whether they were conspiring to hold prices down. Congressional hearings investigated alleged wrongdoing, but the inquiry found little to support the charge that short sellers were the principal villains. Much of the destructive speculation had instead come from investors on the long side, who inflated prices with rumors and stock-buying pools before getting out ahead of the crash.

The backlash nevertheless shaped regulation. Federal rules made short selling more difficult, including a ban on mutual funds selling stocks short that remained in place until 1997. The rules and the stigma reinforced one another: short sellers were imagined as manipulators capable of forcing prices down at will, despite being subject to the same securities regulations against touting stocks or deceiving investors as other money managers.

Why Short Sellers Are Few

The popular picture of a powerful international cabal bears little resemblance to the scale described in the book. The number of full-time short sellers in America could be counted on two hands, and together they controlled less than $20 billion in capital, a tiny amount beside a stock market worth $14 trillion. Hedge funds also short stocks, but shorting is not their exclusive or systematic activity. The market as a whole remains populated mainly by investors expecting prices to rise.

There are practical as well as psychological reasons for that imbalance. Short selling is riskier than buying in a market that tends to rise, and an increase in the price can keep expanding the short seller’s losses. It also means working against the ordinary emotional and institutional currents of investing. Jim Chanos, who headed the short fund Kynikos and was among the first to recognize that Enron was built on a fragile foundation, described a working life in which Wall Street, the news, and company public-relations departments seemed to insist that the short seller was wrong. Buying stocks comes with a steady chorus of support; shorting brings a steady drumbeat of opposition. The difficulty of enduring that opposition helps account for the small share of the market devoted to short positions.

The Information in a Counter-Bet

The case for short selling does not depend on treating short sellers as uniquely brilliant or assuming their pessimism is always correct. Chanos and others have helped uncover corporate misconduct and identify prices built on fantasy rather than substance, but a market should get more than the prices of corrupt companies right. Its broader task is to price companies accurately. That task becomes harder when nearly everyone is making the same kind of bet.

The book’s account of wise crowds gives the counter-bet its importance. A collective judgment improves when it draws on diverse information and opinions, when people can judge independently, and when some mechanism aggregates their separate estimates. A market price is a weighted average of investors’ judgments; if those judgments are drawn from people with different information and perspectives, their errors are more likely to offset one another. Short sellers matter because the reluctance of most investors to bet against a stock weakens that diversity precisely where optimism dominates. Markets may look diverse simply because they are large, but a large crowd that is overwhelmingly positioned on one side is not diverse in the relevant sense.

The comparison with sports betting makes the risk concrete. A football point spread would not automatically be wrong if bettors could wager on only one of the teams, since they would still need accurate forecasts to make money. But one-sided betting would make shared biases more likely, and mistakes more extreme, than a market in which bettors could support either side. A stock market with too few short sellers faces the same vulnerability. Restricting short sales does not guarantee that prices will be wrong; it increases the odds that, when a price is wrong, it will become seriously distorted.

Prices, Bubbles, and the Missing Side

The distinction between rising prices and accurate prices is crucial. A rising share price is not itself evidence that a market is working well. If Enron’s price had not risen so dramatically in the late 1990s, the company could not have raised such large sums of capital on that basis, and its executives would not have left with hundreds of millions of dollars that investors might have used for other purposes. The relevant test is whether prices are right, not whether they go up.

This is why the scarcity of short selling matters beyond the fortunes of particular investors. When a stock becomes overvalued, a short seller can act on information and judgment that the optimistic majority may discount. With fewer people able or willing to take that position, the market has fewer ways to correct its own errors. Internet stocks were exceptionally difficult to short, and that restriction may help explain why their prices rose so far. The historical accusation that short selling is a great commercial evil reverses the book’s argument: the more serious danger is a market in which nearly everyone can bet on a rise, but too few can make the case for a fall.