The title is one of the most frequently asked questions of our portfolios.
The simple answer we usually use is that over 90% of our managed accounts are IRA accounts, and we just can’t short stocks or use margin in IRA accounts.
Following is the actual elaborate answer for more sophisicated clients. Since risk is unlimited using short or margin and they could result in total account loss, it does not match our long term investment goal. Mathematically, as we can see from formula below, since Ls could be infinitely large with short or margin on stocks, over the long term (i.e, f is large) it is unlikely to make money if one keeps using short or margin.
Investment Gain = f * (Wp * Ws – Lp * Ls) where,
f = frequency of trades, e.g., trades/year
Wp/Lp = win/loss percentage
Ws/Ls = average win/loss size, Ls = R (i.e., Risk)
Over a smaller sample size, i.e., in the short term, it is possible to make money using short or margin with a few bets, but this is entirely different from our goal to use the same strategy over and over again for long term growth.
It may be easier to understand using a real life example. Let’s use GSIC to illustrate issue. As the chart below shown, in March, 2011, GSIC chart broke down a decenting triangle, has formed a series of head and shoulder, and was retraced back to $19 resistance level. Its fundamental valulation ratio is expensive (e.g., P/E at 47), earning is on the decline, so it looked like a perfect short setup, and stop loss can be placed at $20, with profit targets at $18, $16, and $14. The reward/risk ratio seems very favorable.
Assume one trader with a $5000 account, decided to take $500 risk to short 500 shares of GSIC at $19 and place a stop loss at $20. The trader also placed braket orders to cover 200 shares at the first profit target $18, and cover 200 shares at next profit target $16, and cover the last 100 shares at $14.
Right after the trader shorted GSIC with the perfect setup and placed all necessary orders to control risk, GSIC gapped up open at $29.41 next day with pending acquisition news, see chart below. So stop loss order was triggerd and 500 shares was covered at $29.41, with total loss more than $5200, resulting in total account loss.
It will probably take a long time to recover from such a trade.
Warren Buffett says it very well in his 2010 Berkshire annual shareholder letter: “History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”