Four Reasons Shorts Are Harder Than Longs

I often hear how hard it is to short stocks. It is true. Here’s a “back of the envelope” proof why:
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1)      Market Trend. The market is upward biased. On average it has risen about 7% per year. That implies that the average stock has also risen that much. Let’s assume 5% to be conservative.

2)      Cost to Borrow. Shorting stocks isn’t free. Stock owners charge stock shorters a fee for borrowing their shares. It can range from next to nothing to 50% per annum. For our purposes, let’s assume 2%.

3)      Management. Company management of the stock being shorted are strongly incentivized to make the stock go up. Company management has the control to influence the price of the stock and they’ll always aim to make it go up. As a shorter (no control) you are betting against those with the most control (management). Assume their power costs the shorter 1% per year.

4)      Asymmetry. Stocks can go up more than they can go down…just ask anyone that was short Volkswagen in October of 2008. In a short bet you can theoretically gain 100% and lose infinity. Asymmetry is a powerful beast in compounding vehicles like a portfolio because losses hurt you more than gains benefit you (i.e. a fund up 50% one year and down 50% the next is down 25% overall). Let’s assume asymmetry costs another 1% per year.

Using this crude math, a short is at a 9% disadvantage to a long on an annual basis (5% Market Trend + 2% Cost to Borrow + 1% Management + 1% Asymmetry). Given that, there is no doubt that shorting is harder than going long.

***I can hear readers saying, “There should be a number five, dividends, however dividends are a wash because the stock goes down by an amount approximate to the dividend. Here are relevant dividend blogs to that end:

http://blog.alphatheory.com/2010/07/dividend-policy-article-with-dr-laffer.html

http://blog.alphatheory.com/2011/04/understanding-dividends-michael-mouboussin-edition.html

http://blog.alphatheory.com/2011/06/debunking-dividend-dogma.html