In a time when people are suffering, there’s something uncomfortable about people who win when the markets lose. But even if profit from others’ failure is distasteful, contrarian investors play a vital role.
Take the German fintech darling Wirecard. Until just a few weeks ago, Wirecard was hailed as a German national success in a tech industry dominated by American companies. German regulators were asleep at the wheel, but skeptical investors raised the alarm and uncovered a multibillion dollar fraud.
The most accessible and common form of betting against assets is short-selling. In this financial maneuver, investors borrow stock, sell it for cash, and hope to repurchase those shares at a lower price before returning them to the shares’ original owner. While short sellers are often dismissed as speculators, vultures, and morally ambiguous profiteers, this is too simple.
As the great Warren Buffet once said, in the short term, the market is a popularity contest; in the long term, it is a weighing machine. Popularity contests don’t always pick the best available options, and the ability to cast a negative vote is actually beneficial to everybody.
When markets are rising, many investors pile in, afraid of missing out on gains. Analysts, advisors, and fund managers are afraid of looking foolish, so they join in too. The very fact that prices are rising becomes justification for more optimism, and sometimes even regulators buy into the same delusion, as with Wirecard. This is a kind of groupthink, and it helps explain why bubbles form, frauds can last longer than they should, and why the next recession is always just a matter of time.
Once we accept that markets are cyclical and excessive optimism is part of that pattern, it gets easier to see why contrarians are so valuable. Investors who bet against the market have to find the most overvalued assets. They have strong incentives to look deeper, focus on fundamentals, and do better analysis.
In this way, short sellers have a vital role in helping markets discover truth. What is an asset really worth? Their work helps everybody avoid the kind of irrational exuberance that leads to bigger bubbles and sharper contractions.
Short sellers take a lot of risk to make their bets. There is no upper limit to the price of an asset and the potential losses for betting on failure are unlimited. To succeed, contrarians need to be “more” right than optimists. They need to be prophets, at least some of the time.
Even if profiting from failure is distasteful, markets don’t need cheerleaders, they need diverse perspectives informed by quality analysis. Despite the queasy feeling, short sellers have my respect.