In a previous article, we have made it clear that in China (most likely more so than in more established Western jurisdictions), both extremes of the investment spectrum are well-represented: from genuine long-term opportunities to more or less reckless short-term speculation options. Through this post, we will be taking a closer look at the latter so as to determine whether or not it might be a good idea to profit from ultra-speculative assets not by acquiring them in the hope of finding a proverbial greater fool down the road but by downright short selling them.
For those unfamiliar with the term, the idea of short-selling is fairly straightforward:
- You borrow a certain asset from an entity willing to lend it (most likely with a certain interest rate attached to it)
- You immediately sell that asset on the open market, obtain a certain amount of money and wait
- If things go as expected and the price of that asset collapses, you buy it back cheaper
- You return the asset plus interest to the entity you have borrowed it from and keep everything that is left over
It is fairly obvious that by short selling, you are essentially “betting” that the asset in question goes down in value. This begs the question: if you feel that certain China-related assets are grossly overvalued at a certain point in time, wouldn’t it make sense to generate additional capital by betting against them?
The answer is yes… but with a twist.
In other words, there is nothing inherently wrong with short selling, it is a practice that has been around in one way or another for quite a while and, indeed, fortunes have been made doing just that. Perhaps the most (in)famous example is represented by George Soros successfully betting against the British Pound but, again, examples abound in the investing world.
However, while money can indeed be made this way, short selling comes with risks of its own, just like any other speculative endeavor. As such, it is important to keep a few key thoughts related to short selling in mind, presented in no particular order:
- The market can remain irrational longer than you can stay solvent. This oldie but goldie in terms of investing adages is important to understand because even if you are “right” fundamentally speaking, it can take a long time until the market catches up with you and by the time that happens, you might have already been wiped out. For example, once Japan embarked on its overly-flexible monetary policy, many investors armed with seemingly robust analysis shorted Japanese government bonds. This trade is now referred to as the “widow-maker” and that should make it clear that things did not end well for shorters in this instance, despite them most likely being “right” fundamentally speaking
- Short sellers aren’t exactly the most popular kids on the block. As such, whenever things go sour and let’s say a financial crash occurs, the authorities love blaming shorters for it. Therefore, you need to accept the significant regulatory risk which comes from… well, common sense. The common sense of understanding that if things go wrong, the authorities might crank down on this practice in one way or another
- Short sellers are in no way immune from greed and fear, just like any other investor. You might think you hold the moral higher ground by betting against assets that you believe are on an unsustainable path but in the end, short sellers are market participants and nothing more. Same virtues, same follies
- Timing is of extreme importance, this goes along quite well with #1. In other words, a lot of profits can end up going down the drain due to improper timing of entries and exits. Needless to say, being right is overrated and if it is not accompanied by well-chosen timing, your strategy will prove to be sub-optimal at best
- A lot of financial products are not as sophisticated when it comes to China as when it comes to its Western counterparts. Less experienced players, less than stellar liquidity in many cases and the list could go on and on
- Everything seems easier on Netflix. Believe it or not, there are even documentaries on Netflix and other platforms involving case studies of people who successfully shorted Chinese assets. To say that things tend to be over-simplified in such cases would be a severe understatement
… the list could go on pretty much indefinitely.
All things considered, the conclusion of this article is fairly straightforward: in light of the fact that misallocation of capital as well as stellar investment opportunities abound in China, it does make sense to add instruments through which you can benefit from the former to your arsenal. At the same time, however, there is (far) more to successfully short selling than being “right” and our article hopefully made this reality crystal-clear. Should you require assistance when weighing your options with respect to various capital allocation choices, including short selling, the ChinaFund.com team is here to help.