Dec. 28–Early in the new year, the Securities and Exchange Commission is expected to make it easier for investors to do something they currently show little interest in–betting that stock priceswill drop.

As a two-year experiment, the SEC proposes to abolish its restrictions on short-selling in several hundred actively traded securities.

Short-selling means selling borrowed stock in the hope that the share price will decline.

The SEC says it needs to recognize that techniques for wagering on falling stock prices have expanded since its short-selling rules were adopted more than 60 years ago. Market watchers expect little disruption from the test.

“I think it will have a positive market impact for those stocks that are subject to the program,” said Adam Cooper, chairman of Managed Funds Association, the trade group for hedge funds, and general counsel for Chicago-based hedge fund Citadel Investment Group. “I think it makes the market more efficient.”

Nonetheless, the government’s stamp of approval on easier short-selling sends an important symbolic message to investors:

The old rule of thumb–don’t sell America short–has been replaced by a new directive–watch your back. You need a strategy to avoid losses as well as a strategy to seek gains.

Much ink has been spilled over lessons from the historic bear market, which may or may not be over. Psychologists who study investor behavior tell us we take greater risks to avoid losing money than to make money.

But 2003 was not a good time to study the lessons of managing the risks of loss. Each major category of investing–stocks, bonds, commodities and real estate–advanced. Stock market volatility was historically low.

Only long-term government bonds and short-term fixed-income investments failed to match or beat their historical rate of return. Even Japanese stocks will close the year with a solid gain.

Short-selling was a losing strategy. Hedge funds that focus on selling short lost 30 percent through November, according to the CSFB/Tremont Hedge Fund Index.

This year’s uncharacteristically broad market rebound reflects the extent of the stock market slump, said Mark Yost of Chicago-based Intrinsic Capital Partners.

“Everything is up this year, because we had a one-in-60-year event,” he said. “You have to go back 60 years to find a three-year bear market.”

According to the consensus Wall Street forecast, stocks will advance again next year, but at a slower pace than 2003.

Just as important, next year’s financial market action probably won’t be as uniform. Different types of investments likely will be less correlated, with a more typical spectrum of winners and losers than we saw this year.

“What we will see is a return to textbook correlations,” said Steven Sachs, director of trading at Rydex Funds, one of the leading fund groups in offering funds geared to up-and-down markets.

Sachs said 2004 will be a year of several rotations among investment themes, both within the stock market and across the stock, bond and commodity markets.

“It’s going to be more normal, but it may not look normal” to investors comfortable with the across-the-board gains of 2003, he said.

In particular, Sachs foresees a return of inflation fears and higher interest rates–trends that often benefit certain investments and hurt others.

Managing the risk of investment loss in a more normal market environment boils down to two quite different strategies: trying to make profits when markets decline or trying to seek bargains after markets decline.

For most investors, the second strategy is easier and cheaper than the first.

The rawest approach to making money when markets decline–selling financial assets short–is risky business, with or without the government’s new implied blessing.

That’s because short-selling amounts to taking out a loan that will be called in a hurry if the value of the investment you sold goes up instead of down.

Many analysts believe the recent stock market rally was boosted by short-sellers buying shares to escape their losing bets that stock prices would drop.

Buying “put” options may be a safer way of betting on market declines. The relatively small amount you pay for a put option, called a premium, is all you will lose–after trading expenses–if your bet on lower prices doesn’t pan out.

Most options expire within a year. But the relative quiescence of the stock market this year means that investors can obtain long-term equity anticipation securities–called LEAPS–at fairly low cost, said Ned Bennett, chief executive at Chicago-based OptionsXpress.

LEAPS are options to buy or sell securities that expire in longer periods, up to three years.

“More and more people are playing long-term equity anticipation securities,” he said. “But the premiums have not gotten out of line.”

For less active investors, the best solution to the risk of loss may be to refine the problem, Yost said.

In the last 10 years, shares of Berkshire Hathaway, investor Warren Buffett’s holding company, have returned 17 percent on average each year, well above the 10.6 percent annual return for the benchmark Standard & Poor’s 500 index.

“Berkshire Hathaway is one of the highest-quality businesses in the nation, run by indisputably the 20th Century’s greatest investor,” Yost said.

Yet the stock lost nearly half its value in a chilling 12-month rout–March 1999 to March 2000–when it sank to $41,300 from $80,300. (Buffett doesn’t believe in splitting his stock.)

The secret to risk management in the stock market, Yost said, is to buy valuable companies at a discount. That’s what he did when he bought Berkshire Hathaway after it tanked.

“We try to profit from periods when the market declines,” he said.

No short-selling or put options are required in what is known as a long-only strategy.

What is required is a broadly diversified portfolio of equities, bonds and cash and a willingness to adjust these investments occasionally to take advantage of long-term market dips.

“We like markets that temporarily go crazy,” Yost said. “We welcome periods of market declines. If you’re concerned about equities, reduce you exposure to equities. [Eventually,] discounts become attractive.”

The stock market obviously became attractive to many investors this year. Investors still have plenty of money in low-yielding money market funds to take advantage of whatever seems attractive next year.

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(c) 2003, Chicago Tribune. Distributed by Knight Ridder/Tribune Business News.

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