By Timothy J. Videnka, CFA, CFP®
“To know that you do not know is the highest attainment; not to know one’s ignorance is the lowest degree of folly.”
Situational Awareness is an investment firm founded in 2024 by Leopold Aschenbrenner, a former OpenAI researcher. Its investment thesis was built around something that has become increasingly difficult to ignore: artificial intelligence is likely to require enormous amounts of computing power, semiconductors, memory, electricity, and data-center infrastructure.
That thesis proved remarkably profitable … for a while. The fund generated extraordinary returns by making concentrated investments in companies positioned to benefit from the AI buildout. Success attracted additional capital, and leverage magnified the gains. Then July arrived. Several of the fund’s largest positions declined sharply. The losses themselves were painful but the real problem was that Situational Awareness wasn’t simply investing its own capital. It had borrowed against that capital to own substantially more assets. When prices fell, lenders wanted additional collateral.
That is where leverage changes the rules of investing. An unleveraged investor looking at a stock that has declined 30% can decide whether the investment thesis remains intact. If it does, the investor can hold the position. We can even use the decline as an opportunity to purchase additional shares at a better price. A leveraged investor may not have that choice: the lender doesn’t particularly care about your five-year thesis – they want their money. And they want it now.
Situational Awareness reportedly lost approximately 67% during July and was forced to sell much of its publicly traded portfolio as falling asset values generated margin calls. The fund wasn’t necessarily forced to sell because its long-term thesis about artificial intelligence had suddenly been proven wrong; it was forced to sell because it could no longer finance the portfolio while waiting to find out if it was right. That is an entirely different problem.
The Three Ls
Charlie Munger had a wonderful way of taking complicated ideas and reducing them to a sentence you couldn’t forget. One of my favorites was his observation that smart people tend to go broke in three ways: “Liquor, ladies and leverage.” As Warren Buffett later joked when recounting the line, Charlie probably included the first two because they also started with the letter “L.” The one he was really warning about was leverage.
We were reminded why recently. Leverage is seductive because it works beautifully on the way up. Suppose there are two investors, A and B. Investor A has $100 and purchases $100 worth of an investment. If that investment rises 25%, A makes $25. Now Investor B takes that same $100, borrows another $200 and purchase $300 worth of the same investment. The same 25% increase produces a $75 gain on B’s original $100. Suddenly, B is not up 25% but rather up 75%. Investor B may begin to believe they’re pretty good at this.
Unfortunately, multiplication works in both directions. If B’s $300 investment declines 25%, they will lose $75. B’s original $100 of equity is now worth only $25. The investment itself declined 25%. And B is down 75%. Somewhere along the way, our lender may decide that $25 isn’t enough collateral for a $200 loan. That is when a levered investment decision becomes a liquidity event. See graphical representation below.
Being Right or Making Money*
This is what I find most interesting about the Situational Awareness story. The lesson isn’t necessarily that its AI thesis was wrong; it may ultimately be right. Artificial intelligence will likely require dramatically more computing power, memory, electricity, and infrastructure over the next decade. Many of the companies the fund owned may ultimately become substantially more valuable. Yet investing has an inconvenient requirement: you have to survive long enough to make money. A leveraged portfolio can take that decision away from you. When markets fall, an unleveraged investor has time. A leveraged investor has a counterparty (the lender) – and the counterparty gets a vote. John Maynard Keynes is often credited with another wonderfully concise observation: “Markets can remain irrational longer than you can remain solvent.” Whether the market is actually being irrational is almost beside the point.
Keynes’s larger lesson is the important one: being right eventually doesn’t do you much good if you can’t hold on long enough. That is the danger of leverage. It introduces a clock into an investment thesis, and usually at the worst possible time. Without leverage, we can own a good business, watch its stock price decline and – assuming our analysis remains intact – wait. We may even have the opportunity to buy more at a lower price. With enough leverage, however, someone else gets to decide how long we can wait. The market doesn’t have to prove us wrong; it simply has to stay against us long enough. That is a very different kind of risk and one that doesn’t show up particularly well in a spreadsheet when everything is going up.
*” Being Right or Making Money” is the title of a book written by Ned Davis.
Concentration Matters, Too
Leverage becomes particularly dangerous when combined with concentration. At the end of June, more than half of Situational Awareness’s reported U.S. equity portfolio was concentrated in just two semiconductor companies. That can produce spectacular results when both investments move in your favor. It can produce something very different when they don’t.
This is one reason we at Forza Wealth Management spend so much time thinking about position size. We don’t believe diversification means owning hundreds of securities simply for the sake of owning them. We also don’t believe any single investment should have the ability to permanently impair a portfolio. Our general preference for individual positions below roughly 5% isn’t designed to prevent investments from declining; investments will decline. Diversification is designed to control the amount of damage any one mistake – or unexpected event – can inflict on the whole. There is an enormous difference between being wrong on 4% of a portfolio and being wrong on 40%. Add borrowed money to the latter and the difference becomes even more dramatic.
Staying Power Is Key
There is nothing particularly exciting about liquidity, diversification, position limits or avoiding leverage. They don’t generate great cocktail party stories. Nobody brags that their portfolio had plenty of liquidity during a bull market. Risk management often looks unnecessary precisely when markets are behaving well. Then something changes. That is when you discover whether the portfolio was built to maximize returns or built to survive. And those aren’t always the same thing.
At Forza, we would rather give up some of the spectacular upside that leverage and extreme concentration can occasionally produce in exchange for something we believe is much more valuable: staying power. The objective isn’t to have the highest return during the best six months; it’s to compound capital over decades without allowing one position, one theme, or one bad stretch of markets to knock us out of the game. Charlie Munger understood that. Liquor and ladies may have made the quote memorable; leverage, however, was the warning.