What is Short Selling? and Is Short Selling Bad? – Answered

By on December 14, 2011 in Investment, Short Selling

One of the most interesting statements you hear as an uneducated investor, either from some news organization or from your Uncle Larry–an expert on, well, everything– is that short selling stock is a bad thing. As a “shorter,” you are evil since you want a company to fail, want their stock to go down, want their dog to die. You mean person. But in reality, is short selling really bad? Is it something we should avoid as budding investors?

First, a little about short selling (aka: shorting, shorting a stock). Shorting a stock is borrowing a stock. Since you don’t own the stock, you must replace it when the owner wants it (or you are done with it).

Here is a timeline for shorting a stock successfully:

  1. You decide a stock is overvalued. For an example, we’ll use Netflix. Right now, Netflix is trading for about $75. If you feel like the stock will go down $5 this week (or today or this month), you could decide to short that stock. (Note: the stock must be in an “uptick” or not be falling to short it.)
  2. You tell your broker (online or person) you want to short Netflix. You BORROW 100 shares of Netflix; this is borrowing from other investors using the same broker that own Netflix stock. You then sell the shares you borrowed for the current market value of $75. This will leave your assets at $7500 and your liabilities (what you owe) at 100 shares of Netflix stock.
  3. At the end of the week, you are right (nice job!) and the price is now $70 for a Netflix share. You buy 100 shares of that stock and then give back those shares to the person who you borrowed them from. This would leave you with no liabilities, since you replaced what you borrowed. But in your assets column, you will have the price you sold the stock for minus the price you replaced the stock for ($7500-$7000), leaving you with a $500 profit. Not bad!

That is the general idea behind shorting a stock. In traditional investing in stock, to be successful, it is imperative to buy low and sell high. This is key in business, investing, etc. In shorting, you at still doing each of these, but in reverse order. In short selling, you sell high and then buy low. Regardless of order, a profit is made.

What is the benefit of shorting a stock? One benefit is using knowledge that a company is overpriced to turn a profit. This allows for investors to profit from both a stock’s going down or going up.

Keep in mind, there are caveats to shorting a stock. The biggest of which is that potential losses outweigh potential gains. The potential gain when shorting a stock is limited by how low a stock can drop. On the other hand, the price a stock can increase (in theory) is infinite. Of course, there are ways to limit losses (stop order, etc.), but it is important to understand either way. This is contrasted with “going long” or traditional investing, where the potential losses and gains are exactly the opposite of shorting.

Potential Gains and Losses in Short Selling

The next question: Is short selling a bad thing?

The short answer, at least from my research, is NO, SHORT SELLING IS NOT BAD.

While some think shorting a stock leads to volatility in the market, the actual result is LESS volatility.  In shorting, there are both more buyers at the low prices and more sellers at the high prices. This will lead to lower highs and higher lows.

This decrease in volatility is good for investors. Less volatility means fewer short term losses for traditional investors.

Market With and Without Short Selling

Opponents to shorting of stock say untrue rumors get started, driving a stock down, helping those who short stocks while hurting normal investors.

There are ways the market doesn’t allow this (or at least limits it). One regulation prevents shorting a stock that is already on the decline, so investors won’t “game” the market by driving the price lower and then profiting by “going long” as the price goes back up to the proper level (a price equal to the company’s worth or investors’s perception of that worth).

There are instances where short sellers game the market, but these are limited. More times than this happens, though, company executives drum up rumors/do other shady things/cover up bad practices to increase the price of the stock to help the company. While naughty short sellers try to convince investors a stock is worth less than it really is, many companies try convincing investors their stock is worth more than it really is. Some of the methods for doing each can be less than honorable. This doesn’t say short selling is bad any more than it says all companies are bad. It is just the nature of the market.

So is short selling a bad thing? I would say no, but I’m by no means an expert. You do your own research. Or you could just trust your Uncle Larry.

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Basic Economics: Let the Market Control Scarce Resources

By on November 8, 2011 in Basic Economics, Book Reviews

I’ve been reading Basic Economics by Thomas Sorwell and thought I would offer a few thoughts on the first couple of chapters.

The preface and first couple chapters offer a general overview of a market economy.

What Sorwell says he offers here is an easily readable economics book, which he claims is a rarity in the field. Although I’m no expert when it comes to economics books in general, I have found the start of Basic Economics to be a very interesting and easy read.

There are a few key points I found interesting/important:

1. Economics is the “allocation of scarce resources which have alternative uses”

This idea is a simple one. When there is a resource and multiple needs for that resource, the decision as to where to allocate those resources makes up the basis for economics. In a free market economy, the decision as to the allocation of those resources is determined by the market itself, which works under the supervision of all of the consumers in that economy. For example, if gold, a very scare resource indeed, could be used to either make gold jewelry  or as crowns in dental practice, the determinant as to where the gold would be allocated would be determined by price.  Whichever group willing to pay more for the gold would determine where the gold would be allocated.

2. The allocation of scarce resources is not an all-or-nothing game

Keeping with the gold example, if there was more demand for jewelry gold than for dental gold, it doesn’t mean the gold will ALL be used for jewelry, leaving dentist out of luck. On the contrary, there is an incremental allocation, where 51% to 99% of gold could be allocated to jewelry, depending on the demand of each use and that demand’s effect on prices.

3. Consumer buying habits  aren’t always understood by merchants

When merchants produce goods for consumer purchase, they aren’t driven by knowing what the consumer wants. Not all the time, at least. The producer is driven by the consumer’s buying habits. It doesn’t matter they know WHY a consumer prefers product A to product B. It only matters that product A can be produced to the consumer’s liking and can be sold to produce a profit for the company producing it. The more mature a product, the better a merchant will understood the dynamics between the product and consumer.

4. Greed does not drive the price of a product up or down

Sorwell makes the point that greed does not drive a product’s price up or down. When a company has strong sells of a product that some consider overpriced, either because the price itself seems inherently high or because the profit margin is extremely high, those sells aren’t a result of greed. The selling price is determined by the willingness of the consumer to pay it. In this example, during the next summer, competition has increased for the  product.  The company that “cleaned up” one summer earlier struggles to sell the same product for half the original price. The company isn’t any less “greedy.” Instead, the market has allowed for the price to decrease by way of increased supply.

5. The communist method of a centralized economic control center does not work

The former communist Soviet Union tried to control the allocation of scarce resources in their company by having a  central government-run economy, where the control of prices were not controlled by a free market. The supply of certain good were determined by the government, which would sometimes cause a surplus of some products, while yielding a scarcity of others. While product A was over-produced millions of times over, product B may be needed by millions of people. The problem with this type of economy is that no one person or small group of people can know the consumer’s demand for every product at any given time.

Sorwell estimates that up to 24 million products’ prices were being controlled during the Soviet Union’s height. In addition, the misapropriation of resources extended further than physical goods. Labor was another wasted resource, in that the market didn’t control the ability of a company to turn a profit by limiting the number of employees producing a product, thus causing an overage of workers more times than not. “5 to 15%” of workers weren’t needed, according to Soviet economists.

A summary of the problem with the Soviet style, as described by one of its economists: “there are far too many economic relationships, and it is impossible to take them all into account and coordinate them sensibly.”A free market economy does this for itself.

6. A company’s losses are just as important as their profits in determining price

When a company produces a product that cost more money than consumers are willing to pay, that company must discontinue its production. Just as a company’s ability to make a profit drives up supply to meet demand, the inability of a company to sell a product at a sufficient price to continue production decreases supply to meet demand. Any company that continues to produce a product they must sell at a loss will eventually go bankrupt. Even if a company wishes to produce a product that doesn’t make a profit, the market will eventually correct this problem.

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Skipping Straight to Investing – What I’ve Learned in 24 Hours

By on November 3, 2011 in Investment

Here are a few tidbits I’ve learned over the last 24 hours reading various resources over the internet and on my Kindle.

-First, over the long term, stocks have outperformed all other investments, while in the short term, well, sometimes they haven’t.

-The price of stock in the short term may be influenced by the feelings of investors, a negative outlook of the company because of some internal issue (corrupt CEO, for example), among other things. However, over the long term, a stock’s price is influenced by a company’s earnings. When a company earns more, so too does the stock.

For example, Netflix recently caused a stir when they decided to change their subscription plans (by separating streaming and DVD-by-mail services), thus causing a short-term fall in their stock prices; this was a change they subsequently cancelled. Only later, with the loss of subscribers (and therefore earnings) did the stock fall again. But over the long term, if they recover and continue to show increased earnings, their stock will continue to appreciate, despite the recent controversy.

-Over the short term, the stock market is a zero-sum game, where there the winners’ winnings has to equal the losers’ loses. This is especially true for day traders. For swing trading and long-term investing, this isn’t true. The stock market will generally grow over time, allowing for there to be more winnings than loses.

-There is an inverse relationship between interest rates and stock prices. As interest rates go up for bonds and other fixed-interest investments, more investors will pull their money out of the stock market and invest in these safer rates. The higher the interest rates go up, the more attractive these options become because the earnings to risk ratio becomes higher.

If you could earn 2% guaranteed (bonds) or 8% (stocks) most likely, what would you choose? What if I said you could earn 5% guaranteed or 8% most likely? These numbers are made up, but serve to show how changes in interest rates among different investment options (which have different risk factors) can affect one’ s decision to invest in one or the other. This is a general observation and not one that is universally true; more of a general trend.

-The price of a purchased bond will change as interest rates change. If you buy a bond paying 5% per year for $500, you would earn $25/year of income. If the interest rates paid on the same type of bond decreases to 3%, the price of your bond will increase to $833.33, since to get the same $25/year at a lower interest rate of 3%, the bond price has to increase. At the end of the bond term, the bond will still be worth $500. The change in price is a transient one, depending on the going interest rate for the bond you purchased.

This leads to two different bond buyers: speculators, which buy the bonds, hoping interest rates fall, allowing for them to be resold for a higher price than they were purchased for, and savers, who are simply wanting to earn the interest and cash in the bond at its maturity.

These are some investment facts/ideas that I didn’t know prior to doing any research. These are only tidbits, like I said before, and don’t constitute entire ideas or any substantial headway in terms of investment knowledge. But a lot of small ideas lead to big ones, which hopefully one day turn into big profits. Until next time, I’ll keep reading. I hope you do too.

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Why a Blog and Why “Money101″

By on November 3, 2011 in General

This is my first blog post at Money101.me and I have to admit: I am excited. My friend Michael inspired me to start this site and to increase my knowledge.  I thank him and anyone else who takes the time to read my posts.

As a child, I was always interested in money. I enjoyed making it and spending it. It always sparked my curiosity how people with a little piece of paper could buy something, while other people without that paper couldn’t. At a young age, that seemed arbitrary and kind of silly. I didn’t understand the concept of money, it not being limitless or the work that went into earning it. I distinctly remember asking my mom why she wouldn’t just write a check for some toy I wanted. After all, she had an entire book of them.

And now, at 26 years old, I can’t say my interest in money has changed much, although my understanding of it has a little.

I guess you could say I am looking to achieve the American dream. I finished high school, joined the Army, was honorably discharged, went to college, majored in chemistry, went to grad school for physiology and am currently working on a Doctorate of Medical Dentistry degree (as of 2011).  I like to think I’ve played by the rules along the way (for the most part) and avoided landing any addictions or in a jail cell. I just got married this year, in fact.

And while I’m happy with my choices thus far, I am looking forward to having the ability to provide for my wife and future children one day. I’d even like to be able to provide for my children’s children if possible. To be sure, I have plans to achieve financial prosperity.

And yet, I am currently 6 figures in debt, most of which came from student loans, and when I graduate with my DMD degree, I’ll be approximately $400k in the hole. I go to a state medical university, but it is one of the most expensive, and I also had to take out loans through undergrad and grad school. The way I figure it, I have a long way to go to reach that financial prosperity. Hell, I have a long way to go to even become financially stable.

When I tell someone I’m going to be a dentist, I usually get a “lucky you” look and/or comment. It is flattering, but also frustrating. I know most would love to be on their way to a dental degree (and in a lot of ways, I am), but after all the student loans, interest on those loans,  and start-up costs of opening a practice, I don’t feel so lucky.

Most dentists out of school do one of two things (well, one of three… I’ll explain). The first is they go into a residency. While a few go into specialties like orthodontics, periodontics, etc., a great many go into general practice residencies. These pay about $50k/year. The second option is to become an associate at a current practice or company (think: Kool Smiles), where salaries usually run about $100k. The third option is for those that are lucky enough to be financially capable of starting their own practice or have a parent (or other relative/friend) with a dental practice ready for takeover. With student loans near half a million dollars and no family/friends with offices ready for takeover, no bank would consider funding the third option for me. That leaves options one and two.

In a residency, loans would be deferred and interest will accrue. The associate route will mean approximately half my salary will go toward student loans, leaving 50k/year minus taxes. That doesn’t leave much for living, investing or saving for a new practice. Thinking about it all can leave any student in this situation frustrated. It leaves me wanting to take financial steps forward faster than the slow walking pace the dental profession will allow. Jogging 12 minute miles over the past 7 years has gotten old–fast.

So here I am, starting a blog about money. Why does the web need another blog? It probably doesn’t, but it will serve as my motivation. Motivation to learn, motivation to find a way to the prosperity I mentioned before. The blog part is a natural progression for an ex-internet marketer. Back in 2007, I made some money (~$30k profit) online promoting ringtone offers from Azoogleads (now Epic Direct) and still have a few sites online. I don’t make much money from them right now, but I have a few new projects I’m working on. I am hoping they will provide some  source of revenue while I’m in dental school. Other than that, I plan to eventually learn to trade on the markets, day trade, etc. I’m sure that is a presumptuous goal, given I’m in dental school and have no background in economics/investing. For those with MBAs and other advanced investment knowledge, it may even seem like an impossible pipe dream. But like I said, I’m motivated.

So how will I start? Well, as the domain Money101.me implies, I am going to start with the basics. I would guess that I understand more than the average person my age about economics and personal finance, but I think a good base would be very helpful. For those that come to read about my journey who have advanced knowledge about all things “mula,” my posts may seem very elementary to you–maybe even like common sense. I’m sorry for that. I hope you will take the time to read my posts anyway, as your support and advice (Please comment!) will only work to further inspire me. I hope to get to a point one day where my posts will serve as advice and inspiration for others.

First order of business: making a plan. If you have stumbled across this blog and are lucky enough to hold helpful financial knowledge, I ask for your help now. What should I read? What should I study first? Personal finance textbooks? Internet resource? What would you recommend to me? I’d love for your advice. In return for that advice, I’ll try to reward you with what I hope will be interesting commentary on the trials and tribulations of a dental student trying to learn the ins and outs of investment and finance.

I’ve packed my bags and am ready start on this journey. All I’m searching for is my pot of gold. It can’t be that hard to find.

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