Is Short Selling Evil?

Whenever the economy gets ugly, short selling heats up -- and so does the debate whether it does more harm than good. Investors with pessimistic view of a company think it is overvalued, so they either short its stock or buy its credit default swaps. Sometimes, they do both. Although shorting has long been considered a legitimate investing strategy by a consensus of market participants, some have criticized short investors for creating pessimism or fear about the companies they bet against. Is there any real value in the practice?

The Washington Post's Steven Pearlstein doesn't think so. In a column this week, he assails short selling, asserting that nothing good really comes from betting against a company. In doing so he suggests that there are four "fallacies" on which arguments in support of the practice rely. Let's consider each separately to see if there's anything to his argument.

Betting a Company Will Fail Is Equivalent to Betting It Will Succeed

This is the most important "fallacy" of the four. Here, Pearlstein essentially suggests that markets are meant to help companies create value. As a result, shorting a company is nothing like investing in its success. Indeed, it's the opposite.

But in fact, Pearlstein falls pray to a fallacy of his own here. The market doesn't merely exist to help companies, but also to make investors money. Investing is a two-way street. In an ideal world, investors would simply put money in good companies and everyone would profit. But this isn't an ideal world.

Some companies engage in fraudulent behavior and others make dangerous or stupid strategic decisions. The short investor works to expose such problems, and that benefits all investors in the long run. Indeed, it benefits the entire economy in the long run, as an overvalued company or set of companies distorts the market. Short sellers might not directly create economic value, but they can prevent or limit its destruction.

All Financial Instruments Have the Same Economic Value

This one is more of a straw man that a fallacy. Even if all financial instruments are not created equal, that's different from saying one is necessarily worthless. In other words, long investing can -- and certainly is -- more valuable than short investing. That's why it's so much more prevalent. But as just explained, shorting a firm can also have economic value, so it is a practice that should continue to be allowed.

More Liquidity Is Always a Good Thing

The argument Pearlstein appears to make here is that being able to protect against a loss in a security can actually overinflate it. He says that's because hedging gives investors a false sense of security, since liquidity will still dry up if a credit crunch hits. Again, I think we have more of a straw man here than a fallacy. Even if shorting did nothing for liquidity, it would still have value. And it's frankly sort of odd to suggest that hedging does more harm than good.

Short Investors' Profit Is a Gain for Society

Here, Pearlstein argues that shorting is a zero-sum game, and he's completely right if you look at it in just one dimension. While it's true that any money a short investor makes, a long investor must be losing, there's more to the story. Imagine a short investor that identifies an artificially inflated stock price. Society's gain is the market correction that the successful short investor helps bring about. A healthier economy is one in which assets are reasonably valued -- not overvalued.

To understand why shorting is so important, let's think about an example of a failed firm that most readers are probably very familiar with: Enron. There was massive fraud involved in the firm's dealings. Imagine if some savvy investor analyzed its financial statements and realized that there must be some shenanigans going on. She then shorts the firm and goes on a campaign to expose the truth. Let's say she succeeds. She makes quite a bit of money, but there is also a clear benefit to society -- Enron's scheme would be brought to light. Its management would stop reaping big profits based on lies and deceit. Instead, investors would shift their money to firms with legitimate money-making potential. The economy is much better off.

Now this is an extreme example, but the same analysis can be cross-applied to even an overvalued firm where fraud isn't present. Investors should know when the market is getting too carried away. That can help to prevent bubbles, the avoidance of which has become one of the biggest challenges markets face. If only there were more bold investors that began shorting the housing market in 2005 and 2006, or tech stocks before they got out of hand in the late 1990s. Short investors help to expose irrationality in the market, and that makes everyone better off.