We live in a very fast-paced world with more access to information than we could have ever dreamed of having. While it has its benefits, it has created an impatient society that seeks out immediate gratification. This mentality is very applicable to investing. Greed and the fear of missing out (FOMO) can lead to some bad decisions in the pursuit of reaching our financial goals quicker. Enter leverage.

To put it simply, leverage enables an investor to borrow money to buy more of a stock than he or she would be able to afford using the assets in the account. Why buy 100 shares of a stock if you can buy 150 or 200? That thought process works fine when the stock is going up, but what happens when it goes down? You borrowed money to buy those extra shares, so you either have to sell the stock at depressed prices to pay the lender back or you have to come up with the cash.

Markets have a funny way of rewarding greed right before they punish it. Just ask Leopold Aschenbrenner from the Situational Awareness hedge fund. While the name of the fund couldn’t fit more perfectly with the story, his nickname from some media outlets could be even more fitting. At just 24 years old, he grew his hedge fund to a peak of approximately $45 billion and became known as the “Nostradamus of AI.”

The interesting part is he may very well deserve that nickname. He understood AI very well and was able to identify AI companies that produced enormous returns in a very short period of time. The problem wasn’t necessarily his investment thesis. It was the amount of leverage he used. If you’ll allow us a little pun, he may not have been aware of the situations that leverage could put him in.

A large sell-off in AI stocks in July forced his hand. There are reports indicating he used leverage of nearly four times his capital. The fund dropped 67% to approximately $15 billion in a few weeks and he had to sell most of his equities to another hedge fund at discounted prices. Even if he ends up being right in the long run, his leverage level took away the opportunity to wait it out.

We can learn a lot from this story. While our average reader probably isn’t going to have access to the type of leverage Aschenbrenner had, there are certainly opportunities available to them. Leveraged ETFs have exploded in popularity among everyday investors. Assets in leveraged ETFs recently reached a record $218 billion, more than four-and-a-half times their level in June 2020. Despite representing only a small percentage of overall ETF assets, leveraged ETFs have recently accounted for roughly 40% of ETF share trading volume.

It is important to understand that leveraged ETFs are complex products designed primarily for short-term trading. They aren’t meant to be held for extended time periods. They are generally intended to produce 2x or 3x the daily return of an underlying security or index. The key word is daily. Because they reset each day, compounding and market volatility can cause their longer-term returns to differ significantly from simply multiplying the return of the underlying investment by two or three.

Time is the most precious asset that all of us have. Everyone from the bottom of the wealth ladder all the way to the top has the same amount of time. When it comes to investing, having time can really work in your favor and long-term thinking usually works out. Conversely, taking time away unexpectedly can be detrimental as the Situational Awareness story illustrates. As Morgan Housel often says, “Risk is what you don’t see.”

We can’t predict every risk that lies ahead, but we can control how much damage an unexpected event can do. Sometimes that means resisting the temptation to maximize every potential return. Owning a little less may mean giving up some upside when things go well, but it can also give you the flexibility and time to stay invested when they don’t. We’re not completely dismissing leverage. We’re simply saying to be careful, know what you own, and remember that sometimes less really is more.

Disclosure: It is important to remember that investments in securities involve risk, including the potential loss of principal invested. Past performance is no guarantee of future results. Diversification does not guarantee a profit or protect against loss in a declining financial market. Alliance also does not make any representations as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party mentioned in this communication and takes no responsibility. This is not intended to be individual tax advice. Alliance Wealth Advisors, LLC is independently owned and operated. Additional disclosures can be found by visiting alliancewealthadvisors.com/legal-disclosures.