Short selling has a bad reputation. It’s been blamed for stock market instability and crashes, and the perceived risk surrounding it has seen governments around the world to ban the practice altogether.
But as maligned as short selling has become, research has revealed that it can, in fact, make stock prices more accurate, and can lead to more efficient corporate investment.
The true effects of short selling on the stock market, corporate activities, and the wider economy are what Dr Xiaohu Deng from the Tasmanian School of Business and Economics has spent years trying to figure out.
“A lot of regulators think that short selling can make the market very risky, very volatile,” he said.
But we show that short selling not only makes stock prices more accurate, it can actually make allocation more efficient.
So what exactly is short selling?
“Basically, short selling is share borrowing,” Dr Deng explains. “When you believe the stock market is going down, you can borrow shares.”
These borrowed shares can then be sold before their price drops.
“When the market has actually gone down, you can buy the shares back at a lower price and then return the same number of shares to the lenders,” said Dr Deng.
In this way, savvy investors make money from a drop in stock price while also returning the original amount of borrowed shares to their lenders.
If that sounds risky, it is. If the shares don’t drop in price as expected, unfortunate investors are left out-of-pocket.
This association with dropping stock prices has left short selling with a bad reputation.
“It’s kind of like a natural human response. When stock prices are going down, they’re scared. They’re terrified,” said Dr Deng. “So the government starts banning short selling.”
But a recent international study by Dr Deng and his co-authors, Professor Vishal Gupta from the University of Mississippi and Professor Sandra Mortal from the University of Alabama in the US, has shown that banning short selling can actually do the stock market more harm than good.
From history, whenever there is a ban on short selling, stock prices don’t get more accurate. Corporate investment actually gets distorted.
The study revealed that banning short selling has been linked to stock prices becoming overinflated, and the cost of equity is artificially lowered, which allows corporations to invest in more projects.
And that’s led to a number of CEOs overinvesting and spending more money than they can afford on unprofitable projects in order to appease their shareholders.
“When they invest in more projects, that can make investors or shareholders happier,” explains Dr Deng. “But some of those investments may not work.”
This inefficient investment has real impacts on the economy, and is a waste of resources, he adds.
“Short selling makes the stock prices more efficient. Some managers and CEOs make decisions by using the information embedded in the stock prices. Therefore, the better stock prices provide better guidance to those CEOs, and their investment becomes more efficient.”
While economic theory argues that the stock market merely reflects the economy rather than affecting it, by looking at data from 14 countries, Dr Deng and his co-authors were able to examine the actual effects of short selling.
“We answered a very important question,” he said. “Whether short selling constraints have an impact on real corporate activities, and whether the stock market has an impact on the real economy.”
They spent years collecting data from regulators and stock exchanges around the world to objectively measure the effects of short selling on the economy and corporate investment, giving them access to ‘real world’ information that’s not available to most researchers.
“The information we obtained is not publically available,” said Dr Deng.
“So when I’m teaching students – especially students with work experience such as master’s and graduate students – I can tell them this is very new information, this very new knowledge. They cannot learn this from traditional textbooks."
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