The correct rationale for the existence of short selling is what we call "price discovery". It is what keeps an efficient market.
When assets bubble and become overvalued, the presence of short selling checks the bubble, and provides some semblance of reality as to the real valuation of the asset.
Of course, in extreme boom times, like the Nasdaq in 1999-2000, these bubbles overwhelm the shorts and get to nosebleed territory.
But in general, the shorters provide checks and balances, both on the upside and the downside. If there were no shorters, when markets decline, they will decline fast, as there is a segment of the market that has been removed from the buy side. Similarly, when markets rise, shorters are there to prevent extreme over-exuberance.
I will address your concerns seriously - as you posed a serious question:
"I am one of those many [to the professionals, "naive"] people who currently do not short the market. I admit to feeling a sense of being cheated when I think about the fact that a market exists where you can sell something you do not own in order to cause the price to drop."
- Firstly, not every single professional trader shorts. They just know what it is all about. Contrary to your belief, shorters do not "cause" the price to drop. Real selling does. Shorters are supposed to take the view that an asset is over-valued, thus shorting it in anticipation of the rest of the world realising it is over-valued and rushing for the exit. Where there is cries of unfairness and disparity, is when hedge funds gang up to short one particular asset class, because it is weak. But that works both ways. You would not complain, if the shares you were long were privy to a concerted ramp up by 17 hedge funds. Similarly, I would not be upset if I was short Babcock and Brown at 20.00 and watch the funds decimate it to break the 8.50 covenant. So you shouldn't feel "cheated" - you're just on the wrong side of the trade. Simple.
- "What if it was decided that banks/institutions or speculator folks could start short selling people's houses to drive down property prices..... Maybe a dumb comparison, but the resulting sentiment for the actual owners of the asset is the same - negative - and this reverberates negatively in other areas of the economy."
- No it is not dumb. There exists a few mechanisms. Firstly by raising interest rates, the RBA tries to curb the rise of housing prices, as people can afford less and less. By trading interest rates on the long side, you can argue you are short housing. But of course, there are those dreaded mortgage bonds that all the banks packaged up and sold to the world. Shorting those in 2007 would have made you multi millions. But like anything, there are two types of owners of property. One - the homeowner, which has zero effect to him how prices move. Two - the investor, which is leveraged, and really that's what shorting all is. Leveraged bets to the downside.
"I admit to ignorance regarding this "removing of liquidity" notion. Who cares if liquidity is removed other than the brokers/funds/bankers/insto's etc who benefit from the volume of trades being placed globally?"
- You are wrong. You are directly affected if your share portfolio requires to be liquidated immediately because a family member needs a loan, or you need to top up your mortgage and find that the spread for NAB is 21.00 bid, 21.50 ask. The withdrawal of a group of market participant will cause severe damage to the liquidity. This impacts the perfomances of your superannuation, global hedging strategies, portfolio transition strategies and macro directional strategies. You might decide to consider then if the removal of shortsellers, option traders (because you can short synthetically there too) and future traders will cause liquidity on the ASX to drop by 50%. Your markets and stocks will no longer be graded investment grade, as funds will NOT want to buy something they can't get out of quick smart.
"Why should I care if noone is willing to sell any of the shares I own because all current holders are extremely strong and confident about the company's future [as far as can be forecasted/ estimated]? I'm truly interested to hear about the advantages to the wider [non-banking] community and economy."
- You do care, because if you one wants to sell, no one can buy. And as such, the price will not go up. Simple.
"tend to equate the existence of short selling with the increase in market volatility and with the existence of trading bots/algorithms plus the fact that the insto's are able to see both sides of the market, there seems to be only one winner in the long term. Like a casino, the odds are stacked in the banks favour, so why should a non-professional trader choose to invest any of their hard-earned money on the bourses in the future? And if they don't, what is the future for the industry? "
- Incorrect. The rise of shortselling is coinciding with market volatility because the markets are falling. Algo/bot traders have been around since 1985. When markets are booming and bullish, there are few shorters and less volatility. The VIX (measure of volatility) spikes when markets fall - hence the coincidence of shorters' existence. And you are in correct in saying the banks win all the time. Read my posts above and you will see all the banks are struggling with their positions. As for your questions of why people invest, you should ask yourself this question and already know the answer. If you don't perhaps this game is not for you.
"o do all the reading necessary would necessitate my leaving my day job and I'm not able [or ready] to do that just yet. Perhaps that simply means I should not trade/invest[?]"
(20min delay)