Ah, the traditional pleasures of September. Summer's heat starts to recede. Pumpkin spice–flavored everything starts to appear on menus. People get in their first complaints of the year at seeing retailers roll out the Christmas marketing before they've even picked out their Halloween costumes. And, of course, here at Fool HQ, the month would not be complete without a mailbag show from Motley Fool Answers podcast hosts Alison Southwick and Robert Brokamp. To help them address all your autumnal financial conundrums, Sean Gates, a financial planner with Motley Fool Wealth Management (a sister company of The Motley Fool), returns to the studio.
In this segment, they ponder possible paths for the pessimistic investor. If you want to bet that a stock will fall, you can short it. Problem is, if your bet turns out wrong, your losses could wildly exceed the amount you had invested. Are inverse ETFs a solution? asks listener Ron. After all, with those, your potential losses are capped. True, say the Fools. But they still aren't fans, and they explain exactly why.
Alison Southwick: The next question comes from Ron. "On last Friday's Industry Focus podcast, there was a question about shorting. I am in total agreement that shorting is super, super risky because of the unlimited downside, but what about ETFs that short the market or an index? I'm under the impression that if I am wrong, I would just lose what I invested." Why don't you start by explaining what shorting is?
Sean Gates: It's basically the reverse of investing in companies for the long term. In this case you're taking a bet against the company that they will do badly. You want to profit from that company doing badly, so you borrow shares from either other investors or from the market and your bet is that that company will do badly and as a result of the deterioration in its stock price, you will gain value.
And typically, it's considered riskier, because when you short a stock you have a potentially unlimited loss potential, insofar as if you buy Amazon at $10.00 a share and you're short, if it goes up to $1,000 a share, you're on the hook for that continuing compound loss. It could go to $10,000 a share, etc. Theoretically, if you held that investment permanently, you would just keep losing money.
Southwick: The market keeps going up...
Gates: Yeah.
Southwick: ... but a stock can only go down to zero.
Gates: Exactly.
Robert Brokamp: What this person's basically saying is if I instead put $100 in one of these short ETFs, in that way he's just risking the $100. So to a certain degree he is right in that he is somewhat limiting his losses.
Gates: That's right. In this case the ETF is creating a portfolio of shorts. You're participating in that collection, and your loss is capped at how much you've invested in that inverse ETF vs. directly shorting stocks, so you get a little bit of downside protection.
Brokamp: If he is looking to reduce his risk in the market, I would generally say these short ETFs are not the way to go. We, here, at The Motley Fool think if you're worried about the market going down too much, just have some money on the side. One of the problems with these inverse ETFs is that they don't often perform as you would expect.
You'd think, "Oh, if the market is down 10%, I would have made 10%." But the history of these is that they often don't perform that way. Sometimes they're a little better and sometimes they're a little worse, but they don't often perform as expected; so, if you're going to use one of these ETFs, research the history to make sure that you get a sense of how they perform given different market conditions.
Southwick: I could see how this could be tempting to someone who thinks that the market's due for a crash.
Gates: Totally, yeah!
Brokamp: Right, exactly. Just in the history of this show, and we've been on the air for over three years, now, we've been having these questions about [why] the market keeps going up. I'm worried. I should do something about that. For example, there's an inverse ETF called "DOG." It is the inverse of the Dow Jones Industrial Average. So if you became concerned in 2014 that the market was down and you bought this, you would have lost money in 2015, 2016, and 2017. At some point, it's just not worth it. Whereas opposed to if you had just moved some money out of the market and put it in cash and bonds, you would have made money along the way.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Alison Southwick owns shares of Amazon. Robert Brokamp, CFP has no position in any of the stocks mentioned. Sean Gates has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.
