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When an investor wants to short a stock, they need to borrow shares from someone else. Why would a shareholder lend the investor the shares?
When the investor gives them back, the stock would be down. So the shareholder lost money, when he/she could have instead just sold the shares and then bought them later at a lower price.
In short (pun intended), the shareholder lending the shares does not believe that the shares will fall, even though the potential investor does. The shareholder believes that the shares will rise. Because the two individuals believe that a different outcome will occur, they are able to make a trade. By using the available data in the market, they have arrived at a particular conclusion of the fair price for the trade, but each individual wants to be on the other side of it.
Consider a simpler form of your question: Why would a shareholder agree to sell his/her shares? Why don't they just wait to sell, when the price is higher? After all, that is why the buyer wants to purchase the shares.
On review, I realize I've only stated here why the original shareholder wouldn't simply sell and rebuy the share themselves (because they have a different view of the market). As to why they would actually allow the trade to occur - Zak (and other answers) point out that the shares being lent are compensated for by an initial fee on the transaction + the chance for interest during the period that the shares are owed for.
Why would a shareholder lend the investor the shares?
Some brokers like IB will pay you to lend your shares: http://ibkb.interactivebrokers.com/node/1838
If you buy shares on margin, you don't have much of a choice. Your broker is allowed to lend your shares to short-sellers.
When I have stock at my brokerage account, the title is in street name - the brokerage's name and the quantity I own is on the books of the brokerage (insured by SIPC, etc). The brokerage loans "my" shares to a short seller and is happy to facilitate trades in both directions for commissions (it's a nice trick to get other parties to hold the inventory while you reap income from the churn); by selecting the account I have I don't get to choose to not loan out the shares.
There are two primary reasons shares are sold short: (1) to speculate that a stock's price will decline and (2) to hedge some other related financial exposure.
The first is acknowledged by the question. The second reason may be done for taxes (shorting "against the box" was once permitted for tax purposes), for arbitrage positions such as merger arbitrage and situations when an outright sale of stock is not permitted, such as owning restricted stock such as employer-granted shares.
Why would a shareholder lend the investor the shares?
The investor loaning his stock out to short-sellers earns interest on those shares that the borrower pays. It is not unusual for the annualized cost of borrowing stock to be double digits when there is high demand for heavily shorted shares. This benefit is however not available to all investors.
Short sellers have to pay interest on the borrowings to the shareholders. Although many times brokers don't pass on these earnings to the shareholders, this is the exchange.
Because they receive compensation (generally interest + dividends) for loaning out the shares.
I own an asset X.
Somebody else wants to borrow asset X for some time period.
I agree to loan them asset X in return for some form of compensation (generally a rate of interest plus, in this specific case, any dividend payments).
The reasons why I own asset X, and why they want to borrow asset X are irrelevant to the transaction.
The only relevant points are the amount of compensation and the risk that they might default on the loan.
This applies equally well to shares as to money or any other kind of loan-able asset.
For the same reason that people bet on different teams. Some think the Tigers will win, others thing the Yankees will win. They wager $5 on it. One of them wins, the other loses.
In a short, one person bets that the stock goes down, the other bets that the stock goes up (or hold). You're basically saying "I think this stock is going to hold it's value or go up. If I thought it would go down, like you do, I would sell it myself right now. Instead, I'll let you have it for a while because when I get it back I think I'll come out on top."
One thing no one else has touched on is the issue of time frame. If I'm looking to hold my shares over the next few years, I don't mind riding out a few short-term bumps, while the short-seller is looking to make a quick profit on some bad news. Sure, I could sell and rebuy, but that's a lot of hassle, not to mention commissions and tax issues.
Some of the issues have been touched on, but there is sort of a mistake in the thinking regarding an investor that believes a share will go up. Total return includes dividends. Also, there are multiple motivations possible in loaning shares for short selling.
Let's start with retail investors first. No share in a cash account for a retail investor can be loaned for the purpose of shorting. Conversely, you cannot generally block you broker from loaning out your shares, without ever telling you they did so, in a margin account. In some cases, though, you can request particular shares to be placed in a segregated cash account.
The exchange the retail investor receives is access to credit at a relatively low cost. If the shares are loaned out, then the broker pays a markup on passed dividends. Instead, the shareholder receives interest that is taxed as interest and not dividends. The markup is designed to cover the tax effects.
For institutions, they receive a fee to allow securities either to be loaned or placed under repurchase agreements.
Now let us consider the case where the fee is zero, why would anyone still do that? Imagine that you own shares in XYZ that you purchased at $5 per share that currently sells for $25 per share. You believe the present value of future dividends for the firm is $35 per share, but your margin of error is plus or minus $10 so you do not make a purchase. If you loan the shares out and the price falls, then you can purchase more shares. Were it not for the inability to track who buys and sells from whom, you could even purchase your own loaned shares back from the borrower.
Short selling will reduce the price, but that may be something that you want. It can be the case that the markup is very large relative to your actual tax obligation. Since the broker cannot see the true tax rate for the customer base, it must markup the cost of the passed dividend to the highest rate. For a firm that does not pay dividends, a key defense is against short sellers is to start paying a dividend.
Imagine that you have long felt that the firm should be paying dividends, but the board is not issuing them. Allowing short selling can trigger the very dividend you want but at a very marked-up price. Also important, the dividend payment may cause the long-run price to be higher than the current price.
