“Persecution is the first law of society because it is always easier to suppress criticism than to meet it” – Howard Mumford Jones

Over the past year, there has been an outcry from company executives and the investing public about short-selling. Short sellers have been blamed for reaping profits from the downfall of good companies with their “bear raids” and “rumor mongering” while John Doe is left to suffer the losses. And if you believe that, you probably think that Bear Stearns and Lehman were fine institutions that would have prospered if not for those nasty bears. In an effort to educate the general public, I am going to discuss the mechanics of a short transaction, the rationale behind a short transaction, the benefits provided by short sellers to the markets, and why blaming short sellers for your losses is simply “passing the buck” and not taking responsibility for your own poor investment analysis. (See my article on taking control of your money and your life.)

1. Mechanics of a short transaction
The first question I always get is “How can you sell something you don’t own?” Well, let’s take a step back and examine a regular buy and sell transaction. First, assume that every share of XYZ stock is issued on a stock certificate. When you buy 100 shares of XYZ at $10 in the market, you send $1,000 and in exchange 100 XYZ stock certificates are sent to you. The following week XYZ is selling for $15 and you decide to sell your stock certificates. You send your 100 XYZ stock certificates to the buyer in exchange for $1,500 (nice trade!) This is not only pretty easy to understand it is also what happens when you buy stock except that the stock certificates are usually held at your broker. So, now let’s look at a sell short and buy to cover transaction. XYZ is trading at $25 in the market and you feel that the price is too high. You go to your broker and ask them if you can borrow 100 shares of XYZ that you will return to them at a later date. IF, and only IF, your broker is in possession of someone else’s stock certificates, they can lend them to you. Once you are lent the shares you can sell them (the shares you have borrowed from your broker) in exchange for $2,500 cash which goes into your account. The next week, XYZ is trading at $15 and you go back to the market and spend $1,500 to buy back 100 shares. You return the 100 borrowed shares to your broker and pocket the $1,000. This is how it works. As for “naked” short selling (shorting without first finding someone to borrow shares from), this has been illegal for years and continues to be illegal. I do not endorse it and no legitimate short seller practices it.

2. Why do it?
This is a personal preference question mostly. However, my answer is that it provides flexibility. If a stock is not cheap enough to buy, it may be expensive enough to short. You have effectively doubled your pool of investment options in equities. Oftentimes, the best shorts are companies that are frauds (think Enron), fads (Crocs and Heelys), and failing business models (Sirf, Sierra Wireless, Novatel). If you a smart enough investor to do the homework and realize that the value being ascribed to a company is fair beyond its intrinsic value, why shouldn’t you be allowed to profit from it?

3. What’s the benefit?
Short sellers provide a few benefits. First, they act as a check on promotional/fraudulent management. They make Dick Fuld and Jimmy Cayne back up their comments that their firms are fine (Lehman and Bear were fine the day before they went under.) Second, they provide liquidity that would otherwise not exist. This point is easy to make in the current market circumstances where the lack of bids and offers is making trading much more difficult. Third, short sellers provide natural future buyers. If you remove short selling from a market , you can effectively remove all bids. If you want proof, ask China. They saw their market go down 75% from the peak in a straight line essentially and they didn’t allow short selling either. I blame Christopher Cox and the SEC for creating an air pocket in September by banning short selling in financials that exacerbated the fall in October.

4. Caveat Emptor
The worst consequence of all this “shoot the messenger” talk is that people feel comfortable blaming short sellers for their losses in the market. Instead of taking responsibility for their losses or poor analysis, they feel they can attack those that have actually done some work. That is capitalism at its worst. Short sellers are providing a service to everyone by keeping markets honest – Warren Buffett has said as much if you need me to appeal to a higher authority.

I leave you with this thought: Of all the CEOs that have publicly complained about short sellers driving their stock price down, how many of them had a real business when the truth was finally out? Here’s a list to start your research with — LEH, BSC, ENRN, OSTK. If a company has an intrinsic value and a real business model, short selling can do nothing more than temporarily distort the value. So whether you choose to employ short strategies or not, please understand that it’s nothing personal. It’s valuation at work.

1. where your money is coming from
2. where your money is being spent, and
3. where your money is being invested and saved

Not appreciating any one of these three fully will lead to problems at some point. Let’s work our way through each item to see how things can go wrong and how best to manage them.

Where does it come from?
This is probably the item that people have the most control over. For most people, their money comes from one primary source: their job. Other sources of income include dividends, interest income, partnerships, tips, gambling or lottery winnings, or your blog, even. Taking control means being able to reasonably estimate the amount you’ll earn by taking into account the stability and quality of the income. For instance, interest that one earns on US government bonds is probably the most stable and reliable form of income you can get. On the other hand, gambling winnings are probably your least stable form of income unless you are a professional poker player. Your job falls somewhere in between these two and furthermore, various jobs have wide ranges of stability.  If you are a handyman with an established client base, you can be pretty certain that you’ll have a steady job with a steady stream of relatively predictable income as people need your services over the course of the year. If you are an investment banker, you can be pretty certain that it will be feast or famine. Your earnings will be highly variable, your bonus will be unpredictable from year to year, and (currently) you can’t even be sure that your industry will exist in the same form a few years from now. Taking control of the situation requires that you make an honest assessment of how stable your income is. Ask yourself these questions:

1. Who pays my paycheck? Is it the government, a private company, a public company, an individual, or my own business?
2. How much variability is there in my income? Is it commission-based, hourly pay, bonus heavy?
3. How strong is my employer’s ability to pay? Can they withstand a prolonged slowdown in business? (Think: homebuilders, bankers, retailers)

The biggest mistake people make is that they mistake their stellar performance at work for the stability of their job. You may be a star performer but still lose your job if you don’t see the end of the road for your company or industry as a whole. This happens often in the hedge fund world. It’s called netting risk. One guy makes a lot of money and everyone else loses money so at the end of the year no one gets a bonus. You would feel cheated if your performance was up to snuff and you were left out in the cold.

Understand the risks to your income and you can help yourself prepare for changes when they come.

Where do I spend it?
I won’t spend a lot of time talking about this because there are countless articles on the web about budgeting and spending on a daily, weekly, monthly, and yearly basis. My only insight here is to behave like a corporation when it comes to managing your finances, especially if you are a family. This means separating your expenses into fixed costs, variable costs, and one-time/extraordinary costs. Fixed costs are things like your mortgage, property taxes, and insurance; anything that you can’t avoid paying. Variable costs are those things which are easy to substitute for or cut out completely such as restaurants, travel, HBO, designer shoes, etc. One-time or extraordinary costs are things that may happen either out of the blue or very rarely or both such as a down payment for a house, a wedding ring, or a new car.

You should be able to categorize all your expenses into one of these categories. It’ll help you when you decide you need to cut back or you want to let loose a little bit.

Where am I investing/saving it?
You have two choices with money either to spend it now or spend it later. If you choose to spend it later, you have a choice of keeping it in cash or investing it in any asset you choose, preferably one that goes up in value while you wait.

In the case of keeping it in cash, here are a few rules to follow:

1. Find a bank with low fees
2. Make sure your accounts are fully-insured by the governmental agency in your country
3. Try to have a savings account that pays a high rate of interest (sometimes it even makes sense to keep money at a bank that will probably go under because it will probably pay very high interest rates in an effort to attract deposits but still be FDIC-insured – WaMu was paying 4% on all deposits right before the end while Chase was paying less than 0.50% so I never moved my money out of WaMu)

In the case of investing your money, it is your job to investigate every asset that you put your money into. You are voluntarily giving up control of your money when you allow someone else to make decisions for you without understanding the risks fully. As you all know, some people have found that their houses are worth 50% less than 2 years ago. Others have found that AAA-rated municipal bonds may not be so safe and so liquid as they once thought. I can’t stress enough how important it is to pay attention to where you are investing your money. It is not acceptable to leave the job to someone else and then be upset when the performance is not as good as you thought it might be. You have the final say.

One related anecdote: I hear 50-100 ideas every week about stocks I should buy or short for my portfolio. People always love one idea or the other. In the end, if I put on one of these trades, it is my decision. The worst kind of trader/investor is the one who blames others for his losses and take credit for his gains. Pointing to Jim Cramer or Suze Orman when you lose money and to yourself when you make money are no-nos. Be an independent thinker and take responsibility.

In conclusion, I hope I’ve motivated you in some small way to think deeply about your money, what you are doing to it, and what it is doing for you. Over the next few weeks, I’ll talk more about the investing side of the equation as that’s where my expertise lies.

Take control of your money.