A reader asks:
What’s wrong with 5x margin, if you can get it cheaply? If everyone earns the 1x market return, what exactly is the point of investing? I’m young and have plenty of time to make it back if my account blows up. So many people are getting rich these days. Why not try when I have no other responsibilities?
Interestingly enough, this question came in a few days before the story broke about Leopold Aschenbrenner’s Situational Awareness fund almost blowing up.
The young AI-focused hedge fund manager made a number of concentrated bets that worked spectacularly until some recent volatility.
Many of the AI infrastructure stocks that hade experienced huge gains fell anywhere from 30-60%. It was a bloodbath for many of these stocks.
The interesting thing is that even with the big drawdowns, most of the AI stocks still have impressive gains in the past 12-18 months.
So Leopold’s fund should have been just fine. There would have been no reason to panic sell these stocks to Citadel at a discount if it wasn’t for leverage.
And this fund used a lot of leverage.
Here are the details from The Wall Street Journal:
For every $1 of capital, Situational would upsize its positions by borrowing an additional $3 to $4, or sometimes more, people familiar with the matter said, well above the leverage used by funds trading such volatile kinds of shares. It also used options to amplify its returns. That meant that even small declines in individual names could have big impacts on Situational’s portfolio.
The use of too much leverage turned what should have been a normal drawdown in highly volatile stocks into a forced sale to one of the most powerful hedge funds in the world at a 10% discount.
Using 4-5x leverage gives you an asymmetric risk profile but not necessarily in a good way.
If you use 5x leverage that means every one dollar you have in capital is paired with $4 in debt. When things are moving up this can be magnificent for your bottom line.
When things aren’t going well, you can get wiped out and receive a margin call. A 10% decline in your portfolio at 5x leverage would lead to a 50% decline in equity.
A 20% decrease and your portfolio is completely wiped out.
And the thing with most brokers is they’re not going to wait for an extinction level event before asking you to pony up some more capital. Your maintenance margin requirement would likely kick in much sooner and force you to sell your assets at a loss.
Marc Rubenstein created a nice visual to show how quickly leverage led to both massive gains and massive losses all in the span of a few months:
Situational Awareness went from $9 billion in March to $45 billion by early-July then back to $10 billion in a matter of weeks.
It was a stunning rise and fall that probably could have gotten worse had Citadel not stepped in to stop the bleeding.
There are more reasonable ways to utilize leverage in your portfolio if you are so inclined. But the use of margin debt has to be far more responsible.
Levering your portfolio at 5x is simply too risky, especially now that the stock market moves at lightning speed. You can be right about the long-term but not make it there in tact if you get margin called.
When I first started in the investment business I valued intelligence and charisma far more than I should have.
After being in this world for more than two decades I’ve now come to value self-awareness and survival more than IQ and flashy stories.
If you want to earn the wonderful long-term returns that exist in the stock market, you can’t become a forced seller when things go wrong.
The longer you stay in the game, the more your capital compounds.
Using too much leverage is a terrible survival strategy.
We had Jack Raines on the show this week to help answer this question:
We also discussed questions about financial advice for people in their 20s, how to deal with the threat of AI in your career, the pros and cons of buying a home and what to do when you get off the grid for good.
Further Reading:
Leverage in the Stock Market
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