Is short-selling a form of diversification?

I.e., if you have stock A and stock B, and you invest (100+X)% in
stock A and short-sell (X)% of stock B, are you holding a (however
minutely) diversified portofolio? Or must diversified portfolios
involve only long positions?

Hi antonb,

Short-selling in itself is not a form of diversification, but a
portfolio with a long position in one stock and a short position in
another, as in your example, is indeed more diversified than a
portfolio with only one stock.

Although diversification is usually described in terms of owning a
variety of different securities or asset classes, the essential idea
is to reduce risk by betting on multiple different things.  With a
short sale, you are betting in the opposite direction, but you still
get diversification, because the investments are independent, and one
may do better while the other does worse.

Going short can be riskier than going long, because there is no limit
to how much you can lose, so in that sense, a short position may not
reduce risk as much as a long position in a diversified portfolio, but
still, it would contribute to diversification by being a different,
independent bet.


Additional Links

As evidence that I am not just making this up, here's a page on Short
Selling that says "Shorting can also provide efficient
diversification...".
http://www.deanlebaron.com/book/ultimate/chapters/short.html

Article on diversification on the Investopedia website.
http://www.investopedia.com/university/concepts/concepts2.asp


I hope this is a satisfactory answer to your question.  If you need
any more information about this, please ask for a clarification.

--efn

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Request for Answer Clarification by antonb-ga on 26 Oct 2005 20:28 PDT

Thanks efn. I'm looking for a more concrete source claiming that
short-selling is a form of diversification. If none is found within
one week your answer will suffice.

Thanks again,
Anton

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Clarification of Answer by efn-ga on 26 Oct 2005 22:56 PDT

I think that will be hard to find, since, as I said, short-selling in
itself is not a form of diversification.  As myoarin-ga noted, a
portfolio that consists solely of a short position in one security is
not diversified.

I did find another page that says "short-selling is still a valuable
diversification technique."  This is in an excerpt from a 1994 article
by Jack Klingler, titled "Do 1980s' timing strategies still work?:
"definitely." (short-selling and market-neutral fund) (Pension Fund
Management )."  As with the quote I posted before, this just supports
the answer to your second question, that a diversified portfolio is
not limited to long positions.

http://static.highbeam.com/f/financialexecutive/january011994/do1980stimingstrategiesstillworkdefinitelyshortsel/

Actually, I think what both quotes are talking about is more like
hedging than diversification.  Both hedging and diversification are
ways of reducing risk by combining different kinds of investments in a
portfolio.  A short position in anything is a hedge (of sorts) against
the market in general going down, while a position that involves a
security or asset class different from the rest of the portfolio,
whether short or long, contributes to diversification.

This page from the Investopedia tutorial on short selling lists
hedging as a possible motivation.

http://www.investopedia.com/university/shortselling/shortselling1.asp

In response to your "if none is found" statement, the way this site
works is that once a researcher has posted an answer, no other
researcher can do so until the first answer is removed. If you are not
satisfied with the answer, the Editors will remove it upon request. 
Until that happens, if I don't post the information you seek, it will
only appear if someone volunteers it in a comment.  I just wanted to
clarify that it is unlikely that another researcher will work on the
question once an answer has been posted.

--efn

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Request for Answer Clarification by antonb-ga on 27 Oct 2005 08:48 PDT

Maybe I should be more blunt. I recently took a finance exam where we
were to sketch the mean-variance curve of a portolio of two assets,
Asset A and Asset B. I claimed that there are benefits to
diversification if short-selling is allowed (the correlation was high
-- .8, but it was possible to obtain a lower minimum variance
portfolio, albeit with a lower return than either of the two assets
individually).

I am not asking for investing advice. I realize that short-selling is
a risky endeavor. But here's the basic problem I have:

Is short-selling really diversification? The problem may be that
diversification means precisely to allocate your resources among many
assets (i.e. invest in more than one asset). Short-selling, as far as
I can see, may not be an allocation of resources in the proper sense.
It is like borrowing money. When going long, I have equity in company
A and an asset that is easily liquidated. When going short, all I have
is cash and the potential to reinvest that cash at a lower price. Is
this really diversification in the true definition of the word?

I guess what it comes down to is whether or not diversification is
defined by mere betting (in which case extra-long A and short B is a
legit form of it), or is it defined by the acquisition of assets that
may earn higher returns?

To me, the betting scenario seems more logical, and therefore, in my
situation, benefits to diversification would exist with extra-long A
and short B.

---

Clarification of Answer by efn-ga on 27 Oct 2005 21:02 PDT

Thank you for the clarification.  It now appears that your question is
about the precise meaning of "diversification."

A case could be made for either interpretation.  All the definitions
of "diversification" I found referred only to long positions.  They
mention "assets" and "investments."  So one could argue that
diversification involves only securities that an investor buys and
owns, since that's all these definitions mention.

On the other hand, it seemed to you, me, and various commenters on
this page that it was reasonable to generalize the definition to
include short positions (the betting interpretation), since the idea
is to reduce risk by variety, and short positions could do that.

I don't think a more definitive answer is possible.  If your request
now is "please find published definitions of portfolio diversification
that explicitly include short positions," sorry, I don't think I can
find them.

You may be interested in this paper:

Levy, M. and Y. Ritov, "Portfolio Optimization with Many Assets: The
Importance of Shortselling", Jerusalem Business School Working Paper.
http://www.anderson.ucla.edu/documents/areas/fac/finance/7-01.pdf

The correct answer to a question is not always what one expects or wants.
Short selling is a technique that usually would only be practiced by
someone with a diversified portfolio of many stocks, so it is just
another choice as a form of investment.
Theoretically, one could have no other stocks - no long position - 
and short sell a certain stock, and would have no diversification at
all.
In your example, holding A and B long, or holding A and shorting your
entire position in B is the the same diversification:  you still are
"betting" on two stocks.  Perhaps, if you only short sell half your
position in B, this could be considered to be diversification.

Please do not consider this anything but an attempt to complement
Efn-ga's answer, which I consider absolutely correct.
Regards, Myoarin

So you're saying that going extra long in A and short in B is not
diversification at all?

Something to keep in mind:

Stocks in general have an upward tendancy.  The market as a whole
averages somewhere around 10% per year (varying greatly of course from
year to year).

Short selling is a simply betting against someone else that a stock
will decline.  So if you make money then someone else loses money.  If
you lose money then someone else gains money.  The net gain is $0. 
Even worse than that, there are fees involved with short selling, so
the net gain becomes slightly negative.  I don't see it as an
appropriate way for the average (or even an experienced) investor to
diversify their portfolio.

I don't think you get the meaning of diversification.

It just means 'putting your eggs in more baskets'

Think of 'eggs' as money and 'baskets' as types of securities.

Or 'eggs' as bets and 'baskets' as horses.

Short selling stocks in share B and buying stocks in share A is
definitely betting on more 'horses' - so it is a form of
diversification.

If you are really thinking about doing this, then I suggest that you
look into buying a put option rather than going short.

Alternatively selling B short and buying a call option in B at a
ceiling that will not bankrupt you if the price of B shoots through
the roof.

To recap, the more horses you bet on, the more diversified your
portfolio, it does not matter whether you are betting that the horse
will come in first or drop at the first fence.

'Diversification' and 'risk' are two totally different things.
A more diversified portfolio could easily be a much riskier portfolio.

And what you are proposing is more 'diversified' and very, very much more 'risky'.

Maybe I should be more blunt. I recently took a finance exam where we
were to sketch the mean-variance curve of a portolio of two assets,
Asset A and Asset B. I claimed that there are benefits to
diversification if short-selling is allowed (the correlation was high
-- .8, but it was possible to obtain a lower minimum variance
portfolio, albeit with a lower return than either of the two assets
individually).

I am not asking for investing advice. I realize that short-selling is
a risky endeavor. But here's the basic problem I have:

Is short-selling really diversification? The problem may be that
diversification means precisely to allocate your resources among many
assets (i.e. invest in more than one asset). Short-selling, as far as
I can see, may not be an allocation of resources in the proper sense.
It is like borrowing money. When going long, I have equity in company
A and an asset that is easily liquidated. When going short, all I have
is cash and the potential to reinvest that cash at a lower price. Is
this really diversification in the true definition of the word?

I guess what it comes down to is whether or not diversification is
defined by mere betting (in which case extra-long A and short B is a
legit form of it), or is it defined by the acquisition of assets that
may earn higher returns?

To me, the betting scenario seems more logical, and therefore, in my
situation, benefits to diversification would exist with extra-long A
and short B.

Also, please don't rush to conclusions and tell me that my answer is
satisfactory when, in fact, it is not. I wanted evidence that going
extra-long in A and short in B is in fact diversification. This
evidence was not provided. I appreciate efn's attempt, and will
provide him with the $5 award if a more concrete answer is provided.

coming late to this party, i'll try to catch up. to the question: is a
short position diversification? yes. some short positions are clearly
hedges but others are clearly diversification and can be such within
an asset class or across asset classes, depending on what you are
trying to diversify.

the comment that a portofilio of a single short position has no
diversification is self-evident. the non-diversified status is not a
function of the short position, it is a function of the singularity of
the position. a single position portfolio is by definition,
undiversified. adding a second position, unless it is clearly a hedge
position diversifies the portfolio. for example, i am long stock A and
go short against the box, although i have added a second position i
have not diversified i have hedged. i am long some converts and short
the underlying in an effort to capture the coupon at less market risk,
again a second position but clearly not a diversification. it is a
hedge. i am long stock A and add a position to the portfolio. the
second position is short stock B. clearly i have diversified my
holdings within an asset class. the short position reduced my total
dependence on the long position to provide me a return. stock A can
now remain the same or even decline and i can be net positive if the
second position out performs stock A. assuming for the moment for the
sake of simplicity, that 100% of capital was in the long stock A
position, then the short B position can only be initiated by moving
assets or diversifing my holdings out of A into B.

assume for the moment that a portfolio is 100% invested in equity
positions. i determine that interest rates are due for a sharp upward
move and wish to exploit for profit that analysis. i initiate a short
position in a fixed income asset. i have diversified my portfolio by
adding a new position which offers me an additional opportunity to
advance values. furthermore i have diversified across asset classes as
i now have exposure to a new market. my diversification isn't
dependent on the fact that i am short bonds, it is defined by my new
exposure in a different market and asset class. as in the previous
example, my equity portfolio can now remain constant or decline and i
can still be net positive if my short postion outperforms the decline
in other parts of the portfolio. similarly i can be reduced negative
if i am correct on the short position but not enough to offset all the
losses incurred on the equity side. diversified is an element of risk
apportionment, not market direction.

there is so much going on in these discussions that i can't remember
all but i do want to address short selling generally. the oft told and
absolutely silly argument that short selling involves limitless risk
because a stock can go up forever is, while technically correct and
useful in classroom exercises fairly useless in the real world. after
managing money for thirty years i have yet to see the price of a stock
go to infinity. the real world day to day risk of a short position by
market movement is all but identical to being long. the real risk in a
short position is that you have to borrow the stock and can be forced
to cover at a disadvantagous point. you have slightly less control of
the position. it doesn't happen often but that is a far more real risk
than the stock you shorted at 85 opening the next day at 6300.

i would also take issue, semantic of course with your view of a long
and short postion. yes, if you are long you own a share of the
company. if you buy your 1500 ge and they liquidate the company you
should realize something in the way of shareholder equity that the
shorts will not. my issue is with the statement that all you have is
cash and the opportunity to reinvest at a lower price. sort of. when
you short a stock the proceeds of the sale flow into the account. so
do the margin requirements of the trade. that's your money. you have
invested your money at a price and are looking for the opportunity to
uninvest it at a profit. the idea that the profit position is a lower
price than position initiation in no way obviates that you made an
investment. you put up real money, when you initiated the position.
your short position is also easily liquidated but i'm not clear what
point relative to diversification that implies. diversification is not
a function of liquidity or marketability.

I would think that short selling would be a part of diversification
but once more, in this strategy, we would have to see the correlation
with our stocks. This correlation would be more the other way around
i.e. -ve of the correlation. If we get a value which brings down the
risk of our portfolio, we could say that short-selling could be a part
of diversification!!!