If you go long the maximum you can lose is 100% of what you invested. (As I did with my smart investment in Enron!)
If you go short, but the shares rise in value, you then have to purchase them at this higher amount. How much is that higher amount? It is limitless. Thus you are exposed to a massive risk that is unknown at purchase.
Imagine you had decided to short Volkswagen before the massive swing in its share price saw its market capitalization hit $364 billion, making it the most expensive company in the world. Many experienced hedge fund managers were on the wrong side of this trade.
Shares prices do move sharply, particularly those thinly traded and small caps. If you are going short, then you could well be in for a nasty shock.
I recommend The Intelligent Investor by Benjamin Graham (first published in 1949).
In response, I wrote,
Questions about short selling and risk came up in the comment thread following Michael Kwan’s original review of Short Screen. I summarized those questions and addressed them on my blog, if you would like to take a look, “Short selling and risk”.
The Intelligent Investor by Benjamin Graham is an excellent book. I have read it and would recommend it as well. Regarding Graham, you may be interested to know that one his first teaching assistants and proteges, Irving Kahn, is, I believe1, still an active investor at over 100 years of age. Kahn is no stranger to short selling. In fact, an article in Smart Money several years ago noted that one of Kahn’s first big investing successes was with a short:Along the way, Kahn got to know many of Graham’s famous disciples, including Warren Buffett. A gutsy Kahn wasn’t swept up in what he calls the “crazy market” of the late 1920s. In fact, his first trade in the summer of 1929 actually was a short sale of Magma Copper that turned out to be a winner in a few months.
1Kahn is still listed under the investment personnel section on the Kahn Brothers website, so I assume he is still alive and investing.