Short sellers and market efficiency

by Sorin Sorescu Assistant Professor of Finance Mays Fellow

My research focuses on the role that short sellers play in improving the efficiency of financial markets. The term “efficient markets” denotes an idealized situation in which the market value of all stocks equals their fundamental (or intrinsic) value. The fundamental value of a stock is the present value of its future cashflows, and for most stocks, the market value is very close to fundamental value. Thus, the U.S. stock market appears to be largely efficient.

But there are exceptions, particularly among small stocks that are not followed by analysts or held by institutional investors. Such stocks can occasionally become overvalued, and sometimes undervalued.

When a stock is overvalued, short sellers play an important role in correcting the overvaluation, and bringing the market value back in line with fundamental value. A “short seller” is an investor who arranges his trades in such way as to benefit from a decline in share value. He does this by first borrowing a stock from another investor and selling it at its current market price. If the short seller’s expectations are correct and the stock’s market price declines in the future, the short seller will buy back the stock at the reduced price, return it to the owner, and keep the difference between the high sale price and the low purchase price as personal profits. Thus, unlike regular investors who make money by buying low and selling high, short sellers earn their living by selling high and buying low.

From a social perspective, it is desirable for markets to be highly efficient. Market prices are frequently relied on to assess a person's net worth, to measure the performance of corporate managers, and for various other resource-allocation decisions.

When markets are inefficient, market prices will be unrelated to fundamental values, and people relying on such prices will necessarily make sub-optimal decisions. Thus, by improving market efficiency, short sellers also contribute to the general welfare of the society.

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