Being short is not automatically evil

We have written before, in posts going back over a year and a half (see here and here), that while our investment philosophy does not involve short-term trading, we do not consider trading to be morally evil but in fact regard it as a necessary component of the markets which enable businesses to raise capital efficiently and allow investors to gain participation in the innovations and achievements of well-run businesses.

This is an important topic, because right now Washington politicians are vilifying Wall Street market makers at Goldman Sachs* for their market-making activities and their alleged failure to disclose everything they should have during those deals.

We are not defenders of Goldman Sachs or any other big Wall Street firm, and we do not know whether or not they broke the law or even did anything unethical. However, the attempt to paint their sales of complicated investment vehicles to sophisticated investors who wanted to place bets on the movement of the prices of securities as somehow "not acting in the best interest of their clients" is political grandstanding, and political grandstanding that can have serious negative consequences for everyone, including regular investors.

As the Wall Street Journal put it last week, the government is trying to paint the issue as a modern version of It's a Wonderful Life, when in fact the transactions in question were more like Alien vs. Predator. The deals in question were not being offered to small investors on Main Street, but to sophisticated trading firms that deal in derivatives and short positions as a matter of course.

While we do not advocate such trading schemes for investors, or pursue such strategies ourselves, we also think it is important to understand that short betting and derivative products are part of the natural landscape that enables the market to function efficiently. Allowing people to place bets on price movements -- including downward price movements -- serves the vital function of enabling liquidity in the markets, and also serves to keep people honest, as we explained in our August 2008 post "Give the traders a break."

Two other recent articles in the Wall Street Journal make this case effectively, and are well worth reading. The first is Holman Jenkins' "The War on the Shorts, Cont." and the second is Gordon Crovitz' "The Misguided Attack on Derivatives."

Investors should understand that the attempts by some in Washington and the media to portray short-term trading functions like short-selling and derivatives as evil are not accurate, and that to the extent that these functions are impaired, the mechanisms that allow investors to allocate their capital to good businesses (especially smaller companies, where liquidity is typically lower to begin with) will also be impaired.

Because we believe that allocating investment capital to well-run businesses in front of fertile fields of growth is the essential foundation of a family's investment plan, we believe this is a very important topic and that investors should take the time to understand it.

* The principals of Taylor Frigon Capital Management own preferred securities issued by Goldman Sachs (GS).

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