Now could be the perfect time for this unusual investing strategy

From as far back as the Neolithic period (9500-8500 BCE), profitable investing has revolved around assets increasing in value. But what isn’t commonly known is you can make money when assets lose value as well.

“Short selling” is a style of investing where traders profit off a stock’s losses rather than its gains. Jacob Little, known as “the great bear of Wall Street”, pioneered short selling in US stock markets in 1822, which paved the way for trading floors around the world to continue finding new opportunities to make money during a down market.

Most stock investors look for companies with strong growth prospects and buy their stocks (ie take a “long position”) in the hope of benefiting when the prices go up over the long term.

Short selling is a popular strategy for traders around the world.Credit: AP

Short sellers work the other way, and target stocks they believe are headed for a sharp decline in the near-term. Rather than buy the stocks, short sellers “borrow” them on the open market, wait for the price to drop, then buy the stocks back cheaper to return to the original owner, meanwhile pocketing the difference.

Successful short selling can be highly lucrative. In 1992, hedge fund manager George Soros, famously known as “the man who broke the Bank of England”, shorted the British pound and profited $US1 billion ($1.56 billion) when the currency collapsed.

Similarly, John Paulson, an American hedge fund manager, foresaw the subprime mortgage crisis preceding the 2008 global financial crisis and netted $US4 billion by shorting the mortgage sector, as popularised in the book and film, The Big Short.

We think the current Australian equity market presents fertile ground for short sellers.

However, short selling is also highly complex and risky. While a long position has unlimited gain potential, and losses are capped at 100 per cent, a short position has a maximum upside of 100 per cent and losses that are, in theory, unlimited.

This is why short selling is mostly used by hedge funds, which specialise in high-risk trading. Famously, short sellers on the wrong side of GameStop’s 2021 price rally lost an estimated $US6 billion, despite GameStop’s total market capitalisation at the end of 2020 being $US1.3 billion.

Many critics have questioned the practice of short selling, citing the potential for bad actors to manipulate market prices as a means of profiting from their short positions. However, the consensus of most financial regulators around the world (including ASIC) is that the short sellers improve price discovery and liquidity, outweighing the potential for abuse.

Indeed, short sellers have been instrumental in discovering some of the biggest corporate scandals in history, including Enron’s accounting fraud in the early 2000s and the Lehman Brothers’ contribution to the collapse of the US subprime mortgage sector ahead of the GFC.

Closer to home, short sellers were behind the downfall of Brisbane-based Blue Sky Alternative Investments, publicly outing the fund’s inflated asset values.

We think the current Australian equity market presents fertile ground for short sellers. A review of stock performance on the ASX shows a wide dispersion of returns. More than 40 per cent of companies in the S&P/ASX 300 had a negative return in 2024, even though the index returned more than 11 per cent overall. This was even more pronounced in Q1 2025, where 56 per cent of companies had a negative return.

The role of short selling in portfolio construction, while historically complex and often underutilised, is something we will see more of in future.

A fund that facilitates yield potential in both directions, for example, has the potential to offer greater gains than a fund focused on one direction only, and this is an area where innovative approaches driven by machine learning and artificial intelligence are starting to gain traction.

Nevertheless, the outsized risk involved with short selling remains, given markets can and often do behave unpredictably. As observed by famous economist John Maynard Keynes, “markets can remain irrational longer than you can remain solvent”.

• Advice given in this article is general in nature and not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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