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Playing the Short Game

The editors of Standard & Poor's weekly investing newsletter, The Outlook, field numerous queries from readers about a variety of topics. Here are answers to two timely questions, adapted from an article in the Jan. 14, 2004, issue:

Q: What exactly is short-selling? Is this tactic advisable?

A: When an investor sells a stock short, he is essentially borrowing shares at a specific price in the hope that they will drop in value. If the stock goes down, the investor can replace the borrowed shares at a lower price and book a profit. Many market participants, particularly long-term investors, dislike short-sellers because they can be vocal in criticizing the companies they are shorting, in an effort to push stock prices lower. Other investors view shortsellers as a necessary force in the market.

Regardless of your opinion, shorting stocks comes with substantial risk. Because a stock's upside is unlimited, at least theoretically, so too is the risk undertaken by someone selling a stock short. Also, the broker who has lent the shares can ask the short-seller to close the position if it looks like the trade is getting out of hand, forcing the realization of a loss. In some cases, short-sellers covering their positions at the same time cause a "short squeeze," a vicious cycle that pushes a stock's price higher.

Because of the risk involved, shorting isn't advisable for most investors. However, there are other less risky ways to profit from a declining stock. One conservative strategy, in S&P's view, is to buy a put option. This would give you the right to sell the stock at a fixed price, but wouldn't force you to do so. In other words, your risk would be limited to the price you paid for the option.

Q: Does reinvesting dividends make much of a difference?

A: Deciding what to do with your dividends will largely depend on your investing goals. For example, if you designed your portfolio with income in mind, then the dividends you receive will likely be used for expenditures. If, on the other hand, you can afford to reinvest your dividends, this can provide a powerful boost to your portfolio's return. The reason is simply the benefit of compounding, which makes reinvesting dividends especially helpful to investors with time on their side.

The S&P 500 index provides a good example. In 2003, the "500" gained 26.4% on a capital appreciation basis. With dividends reinvested, the index rose 28.7%. Over the past 10 years, the index was up 138.4% in terms of capital appreciation, while total return (including reinvested dividends) amounted to 185.5%.

We think the message is clear: Buying dividend-paying stocks and reinvesting the payments can produce stellar results for long-term investors. And bear in mind that stocks with steadily increasing dividends add another dimension to the compounding effect. From Standard & Poor's weekly investing newsletter, The Outlook

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