Stop selling 'short-selling' short

They profit from pessimism. They hope for bad things to happen. They wipe out shareholder value. Those are just some of the criticisms leveled against short-sellers. Such attacks, however, are misguided. Indeed, in the world of investing, few practices are as maligned – and misunderstood – as short-selling.

In essence, short sellers borrow a company's shares and immediately sell them with the expectation that the share price will fall. If it rises, they can face massive losses. But if the price does fall, short-sellers buy back the shares at a lower cost, keep the profit, and then return the shares to their original owner.

The most coveted resource on Wall Street is information, and short-selling is an important – and ultimately beneficial – source of market information.

Markets that allow short-selling (several countries, including France and Japan, have banned it in the past) provide added incentives for people to discover valuable information. When research leads some investors to negative conclusions, short-selling allows them to profit when they correctly anticipate the market's response.

But this strategy does not harm the wider market. Indeed, short selling helps make share prices more accurate.

That's because negative information is as valuable as positive information in directing stock trends. Selling short merely lowers a stock's price sooner than it would otherwise fall. It cannot force the price down for long if fundamental market circumstances do not support it.

Short-sellers have been portrayed as heartless opportunists, benefiting from bad outcomes. But their role in quickly correcting mistakenly optimistic beliefs promotes a healthy market.

Selling short is common in all sorts of businesses. For example, farmers who sell on a futures market when first planting crops are essentially selling short.

Short-sellers are effective market policemen. They often uncover fraud, questionable accounting, and other mismanagement that regulators fail to detect or prevent. The significant short selling activity prior to the collapse of Worldcom, Enron, and Tyco is instructive.

Short-sellers are attacked for spreading negative rumors that sometimes turn out to be false. But rumor-mongering goes both ways. A far larger group – from managers to brokers to financial talk-show hosts – benefits by spreading positive rumors and pumping up stock prices.

Some firms so detest short-selling that they seize any opportunity to deter or disparage the practice. The Economist reported in 2003: "Not long before Tyco went bankrupt it was still buying full-page advertisements to campaign against short-selling."

Similarly, within a month of pharmaceutical firm Biovail filing suit against a hedge fund for selling their shares short and expressing negative opinions about it, the Securities and Exchange Commission announced an investigation that led to a settlement involving serious fraud charges against the company.

Perhaps most telling is a 2004 National Bureau of Economic Research study of the "variety of methods to impede short selling, including legal threats, investigations, lawsuits, and various technical actions...." It revealed that firms attacking short-sellers typically have something negative to hide, since "firms taking anti-shorting actions have in the subsequent year very low abnormal returns...."

Instead of a bad rap, short-sellers deserve esteem. They improve market information. And they help to uncover corporate abuse and regulatory failings, which makes the stock market a safer place to invest. It's time we stop selling short-selling short.

• Gary Galles is a professor of economics at Pepperdine University.