Comments on: The social utility of short selling A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: BenG Thu, 15 Apr 2010 01:46:16 +0000 Socially useful reasons to sell short:

– The short sellers in bear markets or corrections are stabilizing forces, in that they step in and buy when stocks go down to cover their shorts.

– To uncover frauds; many times short sellers identify bad accounting or management teams that are doing wrong.

– To hedge positions for investors in the funds and generate higher risk-adjusted returns.

By: DanHess Thu, 08 Apr 2010 04:05:30 +0000 For the record, it is plain to me that short sellers serve a critical role, because if a price is either too high or too low, capital is be misallocated. My earlier comment should make clear that stock price translates to availability of capital. There are many more mechanisms for translation.

If a stock price is too high, a company is able to get its hands on more capital than it can effectively use and capital is likely to be wasted or destroyed by returns that are too low or actually negative. If a stock price is too low, capital is not flowing to a place where it would be put to good use and have a good return.

By: tk5656 Wed, 07 Apr 2010 15:12:25 +0000 I’m not a follower of Austrian economics, and I don’t agree with Maggie Thatcher’s statement that there is no such thing as society. That said, I think individualism in investing should the ordinary starting point for stack market analysis, and any argument premised on “social utility” is suspect. What’s good about short selling at the individual level is that a short sale today is a promise of purchase tomorrow, and a short squeeze is a great place for a bull rally to start. It puts liquidity in the market. It’s only in the rare situation where essentially all buy side liquidity dries up that short selling seems problematic, but even here it is the short himself who has to arrest the fall by stepping in and covering. Efficient or not, markets need real forces to achieve reasonable prices and shorts are an effective force in this regard. Thought pieces at the 40,000 foot level of social utility are interesting reading, but policymakers should stay well away.

By: MattJ Wed, 07 Apr 2010 13:35:28 +0000 If DanHess is correct about the affects of stock prices on companies, then clearly having an accurate price is socially useful; a stock price higher than deserved sends an inaccurate signal to the companies’ counterparties for each of those transactions.

If that’s the case, then the social utility of shorting depends on whether it is more or less likely to produce accurate values of stocks, as well as how damaging the inaccuracies are in each case. I could see an argument that shorting leads to generally more accurate prices, but the times that they are inaccurate are more harmful than the benefit from when they are more accurate.

I think I need to read the argument against short sellers more fully fleshed out.

By: TinyTim1 Wed, 07 Apr 2010 10:34:51 +0000 Perhaps a dumb observation:
If we are talking about a stock that is going to zero, then the socially useful function of the short-seller is to lower the overall value lost to investors.
Without shorts, the entire market cap would be lost.
With say, 10% of the shares out sold short then that value has been saved since that is exactly how much the short sellers made.

Taking that ad absurdum we should have 100% shares out short and the investment community would never lose money!!
Of course, they would never make it either.

If you want to ban short selling then you should ban selling too. They are one and the same thing, except for slightly different starting points.

By: csissoko Tue, 06 Apr 2010 23:06:44 +0000 Greycap: I don’t think we disagree. You are arguing that short selling adds informational value to the market, which is precisely the argument that I think needs to be made in order for short-selling to be beneficial. You may well be right. I don’t have the knowledge to confirm this independently however.

I don’t espouse the EMH (Efficient Markets Hypothesis), but it is the source of the definition of market efficiency. I would not argue that real world markets are either efficient or fair. But they may, when carefully regulated, be the best substitute for efficiency and fairness that we have.

By: KidDynamite Tue, 06 Apr 2010 22:51:09 +0000 prices reflect the markets net ASSESSMENT of fundamentals. that’s what an efficient market is. it’s kinda like one big cross-product of each participant’s capital and viewpoint. if you remove some of the participants from that equation, it’s less efficient.

i’m not sure why you make it sound like rent-seeking and efficient markets are mutually exclusive. they go hand in hand. the smart capitalize on inefficiencies created by the less smart. that is exactly how markets work. you can call it rent seeking – i call it simply: MARKETS.

but anyway… have a good night.

By: Greycap Tue, 06 Apr 2010 22:41:32 +0000 csissoko, you subscribe to a far stronger version of EMH than I would care to endorse. In my experience, only a small minority of long investors are “monitoring their holdings” in the sense of forming an independent opinion of value. On the other hand, practically all short-sellers are doing so. That is not merely or even mostly because they are professional investors, but because they are running much greater risks.

A substantial body of long investors derive their primary information about value from prices and changes in prices. When this body is large enough, that view is self-reinforcing. When short-selling is not available to restore reason, the critical mass at which runaway occurs is smaller. Perhaps that contradicts the version of economic theory you favor, but it is the way bubbles form in the real world. If economic efficiency is a social good, it follows that short-selling is not just harmless but rather beneficial.

Put it this way: if you accept the proposal that investment bankers are overpaid, and that this excess compensation has attracted talent at the margin that would otherwise have been deployed to better purpose, would it not have been a social good to have been able to set “correct” compensation levels? Unfortunately, IB’s are not traded assets …

By: csissoko Tue, 06 Apr 2010 21:44:19 +0000 KD: According to economic theory, if prices do not reflect fundamentals, then we will have a problem with goods moving from the hands of people who value them more to those who value them less. This is the definition of inefficiency.

If the price of the transaction does not reflect (more or less) the fundamental value of the asset, the “stupid” market participant is providing returns for the “intelligent” participant — but these returns are not the returns of an efficient market, they are rent-seeking gains for the “intelligent” investor.

Now I’m not going to get into a discussion of fairness, but you’re not talking about market efficiency here (at least in the economic sense of the word).

By: KidDynamite Tue, 06 Apr 2010 21:12:52 +0000 very interesting comment, csissoko. although i’d absolutely make the argument that long investors dont monitor their holdings as well as short sellers would, i don’t think one needs to make that argument, and it’s a tangent. i’ll get to that in a minute with your next point:

” More market participants don’t lead to better pricing unless the additional participants bring better information to the market.”

this is also very interesting. it’s beyond the scope of a comment thread, but i think people confuse more robust, efficient markets with markets that price goods “more correctly”. the two are not necessarily the same – the masses can be wrong and the market still be efficient.

and it gets back to social value. if you have an additional market participant who is “stupid,” he is providing social value (and economic value) for the intelligent market participants. One should be able to be a “stupid” short just like they can be a “stupid” long.

maybe the best way to say it is this: a market where every participant is free to express his view in an unrestricted manner is more fair (and more efficient! by definition!) than one with restrictions. I’ll leave it at that.