Why Warren Buffett Avoids Short Selling

So you might think it's easier to make money on short selling, and all I can say is, uh, it hasn't been for me. I don't think it's been for Charlie. It is a very, very tough business. It's an interesting item to study because, I mean, it's ruined a lot of people. It is the sort of thing that you can go broke doing. But being short something where your loss is unlimited is quite different than being long something that you've already paid for.

So short selling is a topic that has been coming up in the news lately, particularly with all that's been going on with GameStop and how a lot of the hedge funds are getting screwed over short selling GameStop stock. What we're going to talk about in this video is, firstly, do a bit of an explainer on what short selling is and how it works. Then we're going to have a look at some advice from the GOAT on why he actually steers clear of all short selling and just does not take part at all.

Now, the first step in the process of short selling is that you're going to sell the stock. What stock? Haven't got any? Well, that's because what you're actually going to do is you are going to borrow somebody else's stock in order to sell it. Now, of course, the idea behind borrowing means that at some point in the future, we're going to have to give back what we borrowed.

So the idea with short selling is you borrow someone else's shares, you sell them, then the share price hopefully goes down. You're going to then buy them back at a later date for a cheaper price and then return the shares to their owner. The owner of the shares doesn't know any different; you borrowed 100 Apple shares, and you gave them back 100 Apple shares. It's all the same to them. But in the process, if the stock price falls, you would have sold those 100 Apple shares for a high price and then bought them back for a really low price.

So whatever the difference is in the buy and the sale price, that's your profit. So that's the basic concept of short selling; that's how you make money from the stock price going down. Now, the only other basic concept to understand with short selling is that, like borrowing anything, usually, the actual borrowing isn't free to do.

You know, if you borrow money from the bank, you have to pay interest. Same thing with the time that you borrow the shares to the time that you give them back. During that period, you will also pay interest. Now, as regular old investors, what we try and do is we try and buy undervalued stocks, right? That's our game. We are trying to buy shares when they are at a discount, when they are on sale, when the stock price is below their intrinsic value.

Now, in reality, most stocks most of the time are not undervalued. In fact, most of the time, most stocks trade at a premium to their intrinsic value. So in theory, it sounds as though short selling might be a more viable approach than regular old investing.

Here's Warren Buffett speaking to that point: "You see way more stocks that are dramatically overvalued in your career than you will see stocks that are dramatically undervalued. I mean, it's the nature of securities markets to occasionally promote various things to the sky so that securities will frequently sell for five or ten times what they're worth, and they will very, very rarely sell themselves for 20 or 10 percent of what they're worth. So therefore, you see these much greater discrepancies between price and value on the overvaluation side."

So you might think it's easier to make money on short selling, and all I can say is, uh, it hasn't been for me. I don't think it's been for Charlie. It is a very, very tough business. So in reality, it's actually a pretty tough business to make money.

Now, there are two main reasons for this, but I'm going to let Warren Buffett explain them first. After he's explained them, I'll come back and add a little bit more color.

"It is a very, very tough business because of the fact that you face unlimited losses, and because of the fact that people that have overvalued stocks, very overvalued stocks, are frequently on some scale between promoter and crook. And that's why they get there. And once they're... And they also know how to use that very valuation to bootstrap value into the business. Because if you have a stock that's selling at 100 that's worth 10, obviously, it's to your interest to go out and issue a whole lot of shares. And if you do that, when you get all through the value can be 50.

In fact, there's a lot of chain letter-type stock promotions that are sort of based on the implicit assumption that the management will keep doing that. If they do it once and build up the 50 by issuing a lot of shares at 101, it's worth 10. Now, the value is 50, and people say, 'Well, these guys are so good at that. Let's pay 200, 400, or 300,' and then they can do it again, and so on. It's not usually quite that clear in their minds, but that's the basic principle underlying a lot of stock promotions.

And if you get caught up in one of those that is successful, you can, you know, you can run out of money before the promoter runs out of ideas. In the end, they almost always work. I mean, I would say that of the things that we have felt like shorting over the years, the batting average is very high in terms of eventual... they would work out very well eventually if you held them through. But it is very painful, and in my experience, it's a whole lot easier to make money on the long side."

So the first reason why a lot of people end up not making any money when they're short selling is because, with short selling, there is the potential that you can lose an unlimited amount of money.

So remember back to that first graphic: remember short selling? We are borrowing someone's shares; we're selling them at a high price hoping that the share price then goes down. We buy back the shares to return them to the owner, and then we profit the difference. Well, what if the stock doesn't go down? What if it goes up?

Remember, with short selling, you always have to buy back the shares to close your short position to return the borrowed shares back to their owner. But there is no limit on how high the share price of any particular company can go. Thus, if you are short selling, you're opening yourself up to potentially unlimited losses.

Imagine this: you borrow and sell one share of Tesla; you sell it for a hundred bucks. Unfortunately, though, the stock price then goes up to two hundred dollars. Well, already you're a hundred dollars in the red. But then the stock price keeps going up to say four hundred dollars. Now you're three hundred dollars in the red. But now, the stock price is at eight hundred fifty dollars.

If you kept your short position open, now you're seven hundred fifty dollars in the red. Remember what I was saying just before the last step of short selling? You always have to buy back the shares to close your short position. There's no limit to how high share prices can go, and therefore there is always the possibility of unlimited losses.

Now moving on, the other reason why Warren Buffett explained it's actually quite hard in reality to make money from shorting stocks is because, say you've found this stock; it costs ten dollars, and you just know it's going down. Like, this thing is so expensive; it's on such shaky ground; it's definitely going down.

However, the CEO, who's more like a salesman, has actually just decided that because it's so expensive, he's going to sell a whole lot of new stocks, say 10 million new shares, that he just creates out of thin air, and he's going to sell them to investors that he has somehow convinced that, you know, this stock is definitely going to keep doing well.

You know, we're going to the moon, etc. Now, as I said, these shares just get created out of thin air; the shares get dumped on the shares pile that grows a little bit. But the company definitely does get all of the funds, all of the proceeds from that stock sale. So say now investors look at this stock and they go, "Yes, it was ten dollars before, but now they just raised a hundred million dollars. They got big plans; they're going to put that money to use, and the business is going to be even better."

So now we think that the business is worth twenty dollars; the stock price goes up to twenty dollars. The CEO goes, "Uh, great. You know, I'm going to use this opportunity to raise even more stock at this outrageous price, convince some more investors to jump on board." Now investors think, "Oh, it's gonna... it's, you know, they're in an even better position," and the process just continues cycling.

Being short something which keeps going up because somebody is promoting it in a half-crooked way, and you keep losing, and they call on you for more margin, it just isn't worth it to have that much irritation in your life. It isn't that hard to make money somewhere else with less irritation.

Now, Charlie raises another good point here in that if you are shorting a stock and the stock price is going up, the more the stock price goes up, the more maintenance margin you're going to have to add into your investing account. Now, because with short selling you're playing around with stocks that you didn't actually own, you borrowed, there is a risk for the broker that they look at Brandon and say, "Geez, this stock price just keeps going up. I'm not actually sure Brandon has the money in his bank account to be able to buy back the shares to return what he borrowed."

Now, to limit their risk, they may force you to add more money into your investing account, into your margin account. That's called a margin call. And if you are unable to deposit the funds into that account, then they can force you to cover your short and close out your position.

So even if you found a stock that you know is going to zero, if it goes from 200 to 400 before it tanks to zero, and you can't meet the margin call that you get, you can be forced to cover your short. Even though your thesis was right, you can be forced to take a loss even though you were right.

This is Warren Buffett talking exactly to that point: "In the end, they almost always work. I mean, I would say that of the things that we have felt like shorting over the years, the batting average is very high in terms of eventual... they would work out very well eventually if you held them through. But it is very painful, and it's, in my experience, it's a whole lot easier to make money on the long side."

So there you go. Even when Buffett thinks about short selling, you know most of the time, well, he's got a very high batting average, aka most of the time he's right. It's more a question of can you maintain your short position long enough for you to actually profit from being correct.

And that is exactly what happened with a lot of hedge funds that were shorting GameStop. A lot of them saw GameStop as, you know, it's a physical retailer of video games; it's a dying business; it's gonna go to zero eventually. However, the redditors on Wall Street Bets were able to spike the share price so much that it forced the hedge funds to close out their short positions.

They could, you know, GameStop in the long run, it might go to zero, you know, it very well could go to zero unless they change something drastic about their business model. But the reality is that those hedge funds, because the share price spiked up so high, they weren't able to stay in the game long enough to see their thesis play out and to profit from it.

Overall, all of these reasons help make up Warren Buffett's mind, and that's why he doesn't get involved in short selling. You know, in reality, it's probably easier to pick a loser than pick a winner. But with short selling, the fact that there are unlimited losses, the fact that you have to maintain your short position, you might get a margin call, the fact that there are phony salesmen out there, that can CEO's out there that can keep the stock prices insanely high on their businesses, just means that in reality, it's actually a much harder business to make money than what you might expect.

And at the end of the day, short selling quite simply just violates Warren Buffett's first rule of investing, which is don't lose money. You don't ever want to put yourself in a situation where you could lose a lot of money. And overall, with short selling, yeah, there's the potential that that might happen.

So anyway, guys, I hope you enjoyed this video. That is my summary of why Warren Buffett does not look to be a short seller. Also, with the size of his company, Berkshire Hathaway, if they're even gonna move the needle with their short selling, they would just have to put like the whole company at stake, and that's just something that they would never do.

But anyway, I'd love to hear what you think about short selling. Personally, I don't do it either, but maybe you do; maybe you've had some experience short selling. I'd love to hear from you if you have. You know, did it work out for you? Did it not work out? Maybe if you've been someone that's done short selling for a very long period of time, let me know your stats. You know, have you made money over the long run? Has it been much more challenging to make money than what you thought?

Let me know down in the comment section below. Leave a like in the video if you enjoyed. Check out profitful links down in the description if you're interested in how I go about my investing, either passive or active investing. But that is it for today. Thanks very much for watching, guys, and I'll see you guys next time.