So here is the ScepticalCapitalist's take on what the primary goal of "rational" investor short selling strategy should be- it is simply called risk mitigation or hedging. I personally believe that it is a very prudent practice for an average investor to allocate a healthy portion of their portfolio- usually no more than 30-40% percent of their "long" holdings to a well diversified group of small short positions. These stocks are intended to serve a primary goal of cushioning portfolio gains in the event of a severe market decline like the one experienced over the last several months.

Assuming that you also you shorted the right stocks (usually on the downtrend already and highly leveraged), this 30-40% position could potentially cushion the majority of your "long" losses even though the actual dollars committed to the "shorts" are 2.5 times smaller, because "weak" stocks tend to "fall off the cliff" much faster than the blue chip names... Yes, it is also true that during the "bull market" your "short" positions could exhibit a small drag on your upside, but it is likely to be small if executed correctly and will reduce the overall volatility of you portfolio.

Now here are some of the simple rules I personally use when picking short positions:

Rule 1- I do not short stocks based purely on valuation- period!
Shorting based on "valuation only" usually means that the stock you are shorting has been going up for a while, and thus you are very likely going to end fighting against a momentum driven crowd that could "stay irrational for longer than you can stay solvent".

Rule 2- I do not short stocks that do not have debt!
Again logic here is very simple- by selling stock short I am in effect saying that there is something fundamentally wrong with company's business model, rather than simply saying that the stock is too expensive. And without pressure of interest payments company can stay afloat for a while, even if the business itself is worthless. Plus there is another upside from focusing on stocks with debt- during bear markets stocks with a heavy debt load decline multiple times faster than the "debt free" ones.

Rule 3- I also only short on the downtrend and in general like for the short candidates to have a short ratio of over 7%.
I found that if I am the only one who thinks that the company is broken- I am usually wrong. Plus buying on the downtrend helps to avoid fighting against the "momentum crowd".

Rule 4- I prefer to short stocks that have negative or declining cash flows, low margin and reasonably low growth expectations.

Once again self explanatory- negative cash flow in combination with debt means trouble. Low margin means lower room for any (even short term) error. And lower than average growth expectations help with potential "buy out attractiveness"- acquirers usually seek "growth" rather than "turnaround" opportunities.

Rule 5- I also usually avoid shorting stocks in biotech and other "high end" research and development heavy sectors.

As I found again in my own experience- unless you have some kind of special insight on the research subject/technology- you are simply betting on an outcome instead of making an intelligent investment decision.

Even in the current volatile market it is possible to find some companies that I consider attractive short candidates. You can find some of them in my profile on MSN's web site. But anyway, I hope some of the above information is helpful for some curios investors out there. So please next time you hear another "disgruntled" manager complaining about "evil" short sellers, please ignore the noise and remember, that while "making money on other people's pain" is usually a great discussion point for populist politicians, the reality is a lot more simple- short selling helps to avoid larger bubbles in the market, and thus could potentially save many investors some serious pain when these bubbles eventually burst.

However, cruel it might sound, it is often more productive to let "bad" companies simply disappear, instead of wasting more productive capital on inefficient and destructive business concepts that are destined to collapse eventually anyway.

"Sickness is simply the vengeance of nature for the violation of her laws"
Charles Simmons

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