AWM Insights Financial and Investment News

Leverage is the sharpest tool in the financial toolkit, and like any sharp tool, it can help you build or it can cut you. In this episode of AWM Insights, Justin Dyer and Mena Hanna break down the difference between consumption leverage and balance sheet leverage, why a 30-year mortgage and a margin loan carry completely different risks, and the guardrails we use before any family borrows against a portfolio: sizing, timing, break-even, the cushion test, and a real repayment plan. The short answer is "it depends," and the biggest variable is who controls the situation. We close with Charlie Munger's famous warning about the three ways a smart person goes broke, and why leverage is the one that can turn volatility into permanent loss.

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Chapters
  • [00:00] Introduction — Why leverage is the sharpest tool in the toolkit, and why the short answer is "it depends."
  • [01:44] The Many Flavors Of Borrowing — Credit cards, lifestyle financing, mortgages, car loans, and student debt.
  • [03:19] Debt Isn't A Moral Question — Consumption leverage vs. balance sheet leverage, and the mortgage as an advance against human capital.
  • [05:21] Borrowing Instead Of Selling — Using leverage to fund spending without realizing a taxable gain, and why it gets complicated.
  • [06:04] Timing And Sizing — Why financing everything to stay invested is a slippery slope, and how margin calls happen in a sell-off.
  • [07:33] Who Controls The Situation? — Mortgages vs. margin vs. pledged asset lines.
  • [10:07] The Break-Even And Cushion Tests — What the loan really costs vs. the tax hit, and how much room you have if things go wrong.
  • [11:41] Repayment And The Weight Room — Why every loan needs a payoff plan, and what lifting weights teaches us about risk.
  • [12:50] Liquor, Ladies, And Leverage — Charlie Munger's warning, and how leverage converts volatility into permanent loss.
  • [14:07] Closing — Send us your questions and feedback.


Creators and Guests

Host
Justin Dyer
Chief Investment Officer and Chief Operating Officer at AWM Capital
Host
Mena Hanna
Senior Investment Analyst at AWM Capital

What is AWM Insights Financial and Investment News?

A bite sized discussion on timely financial news and investment topics, to help you maximize your net worth and wealth for the next generation with Justin Dyer and Mena Hanna of AWM Capital.

Justin Dyer: "There's three
ways a smart man can go broke:

liquor, ladies, and leverage."

Leverage is also a tool, it's the
sharpest tool in the toolkit, if

you wanna think about it that way.

Well, sharp tools, serve a purpose, but
they can also really, really cut you.

Mena Hanna: If you just start financing
everything from, you know, your burrito

bowl at Chipotle because you don't want
to take any money out of the market, or

you potentially want one hundred percent
of your paycheck to go to the public

equity markets, that is a slippery slope.

Justin Dyer: Who controls the
situation is incredibly important

when we're talking about leverage.

Leverage has the power to convert
volatility, especially when

we're talking about balance sheet
leverage, into permanent loss.

Full stop.

Hey, everyone.

Welcome back to another
episode of AWM Insights.

It's your host, Justin Dyer here,
chief investment officer at AWM

Capital, joined as always by Mina
Hana, portfolio manager here at AWM.

And

Mena Hanna: And

Justin Dyer: today, we're
gonna talk about leverage.

We touched on it a little bit in, uh, a
few episodes back, uh, about some, uh,

some strategies that really blew up.

Um, and we just wanna talk about
it even more broadly speaking.

We always say money is a tool to
accomplish what's important to you.

Leverage is also a tool, or it's a,
it's the sharpest tool in the toolkit,

if you wanna think about it that way.

Well, sharp tools, uh, serve a
purpose excuse me, but they, they

can also really, really cut you.

So, um, thinking through leverage,
how to potentially use it, when to

use it, what are the guardrails to
set up in place, um, are really what

we're gonna try to talk about today.

And, you know, the short answer, the
short punchline here is it depends.

It's in- incredibly
situationally dependent.

We all probably use leverage in some
form or fashion throughout our lives.

A good old 30-year mortgage is,
uh, you know, the classic form of,

of leverage, of borrowing money to
accomplish what's important to you.

Um, but that's one use case, and
so we're gonna get right into it.

Uh, Mina, let's, let's, let's go over
some of the more common flavors or, or

versions or sizes of the tool, right?

I, I touched about, touched on
mortgages in my, my intro, right?

Most common, arguably, o-of all,
um, borrowing tools out there.

What else is generally available?

I mean, you know, you could probably
find anything under the sun and, and

structure something any which way,
but we're not getting into that today.

Like, the basics, what
are we talking about?

Mena Hanna: Yeah, there's,
there's a million kinds of

loans, leverage, borrowing.

There's, you know, the credit
cards that we use day to day.

Now, if you pay them off in, in
a month and don't extend them,

that's, that's a different kind.

But sometimes people
obviously leave debt there.

There's a lot of different forms of just
lifestyle financing that can be very

damaging to the hundred-year family.

And then there's useful ways of using
leverage in, in a portfolio or just on

your balance sheet to potentially manage
your, your balance sheet appropriately.

You brought up a mortgage, potentially
a car loan, potentially student debt.

Uh, there's, there's different kinds of
actually taking on debt, where over the

short term it actually benefits you, it
helps you accomplish your priorities.

Sometimes it's also the path of least
resistance and the most efficient way if

you structure it properly, and then, you
know, you're an athlete, you're a student,

you have a career coming up, you have
earnings, you can use those funds to pay

off that debt in an appropriate fashion.

Now, you said it, it's-- there's, there's
a lot of considerations here to be made

in terms of how much debt you take on.

How do you take it on?

Why are you actually taking it on?

Is it to do something
that's actually meaningful?

Is it to finance, you know, a home
purchase, improve your career, or are

you just taking on debt to, you know,
buy a depreciating asset, something

that's just gonna generate no cash?

There's, there's a lot of different
ways about thinking about it, uh,

about thinking about this situation.

I think the important thing is
to take a step back, and this

whole debt conversation is not
a moral question or dilemma.

Not all debt is bad.

Used improperly, debt can be very,
very bad, like we talked about.

Yeah.

Justin Dyer: we say that, but yeah.

Mena Hanna: Yeah.

Um, but sometimes it can actually be good.

You just have to be very thoughtful
about how you implement it

and, and why you potentially
implement it into your portfolio.

Justin Dyer: I, I think
that's a great summary.

So, I mean, even just to, to,
to hit on the finer points.

In our opinion, this isn't a, a
moral question or conversation.

Now, I, I kind of, uh, alluded to
what I'm a-about to say already.

There's really kind of
two, two basic forms of, of

borrowing or, uh, of leverage.

We're, we're gonna use
those words interchangeably.

We're already use- already
using them interchangeably.

But there's consumption
leverage, which is…

That is bad.

I'm just gonna go out there and say it.

That's, that's outright bad.

You should never go on credit
to go to buy something.

But then there's balance sheet
leverage, and when applied thoughtfully,

it, it can be a tool, right?

That's what I said.

Money is a tool to accomplish
what's important to you.

Um, leverage is a tool in your
toolkit to, to fulfill that journey,

to fulfill that 100-year journey.

Again, mortgage is the most
common, um, version of that.

And really, at the end of the
day, what is-- what are most

people using a mor-mortgage for?

It's, it's bridge financing.

You're gonna go buy a house right now.

You don't have the liquidity, or maybe
you have the liquidity, but it would

tie up a ton of your liquidity, um,
at the earliest stages in your career.

Well, you're confident that
you're gonna be able to pay that

house off over whatever it is.

Maybe you're a professional athlete,
it's a couple years or a few years,

um, or you're a professional entrepre-
entrepreneur, you're waiting for that

liquidity event, or, you know, you're
just gonna, uh, be disciplined and

pay that 30-year mortgage off, right?

That is taking an advancement
against human capital.

There's also, um, let's call it
the, the decision to use leverage to

fulfill some sort of spending need
now, so you-- and, and you don't wanna

touch an asset that has appreciated
to prevent taxes being realized.

That one's really complicated, and
you can, you can probably get into,

um, into trouble if not thought
about or not applied properly.

So maybe let's get into,
into that a little bit, Mina.

Like, let's walk through some of the
guardrails we would wanna, um, think

about or challenge people on, or just,
yeah, the general questions that, that

we would and, and do think about when
it comes to that certain use case.

Yeah.

Mena Hanna: An important-- I would
say the most important piece there is

how much are you going to use and how
long is that period going to be for?

If you're indefinitely going to
take on debt because you want money

to ride in the market and you want
markets to do well, and, you know,

everyone wants markets to do well.

Everyone hopes that markets are gonna
do well over extended periods of time.

But if you just start financing everything
from, you know, your burrito bowl at

Chipotle because you don't want to take
any money out of the market, or you

potentially want one hundred percent of
your paycheck to go to the public equity

markets, that is, that is a slippery slope
because at a point, that's gonna compound

into something that you are-- you're gonna
struggle with paying that back, and you're

gonna be at the mercy of public markets.

If public markets don't behave, you get
yourself in a pickle in that situation.

So that's, that's, I
guess, the timing side.

The sizing side is also super important.

If you're gonna take on, sort of call it
fifty percent margin on your portfolio,

you have two million dollars in your
portfolio, you're extracting one million.

If public equity markets sell off like
they did in 2008 or potentially the

early 2000s, you get margin called
like the situation we were talking

about with situational awareness.

So you wanna make sure that there
is a light at the end of the tunnel

in terms of when you're gonna pay
that off and size it appropriately.

Justin Dyer: Eh, so you're, you're
talking about margin right there.

I wanna, I wanna jump in and,
and introduce a, a certain, uh,

uh, important concept here too.

Who controls the situation
is incredibly important when

we're talking about leverage.

Going back to the good old thirty-year
mortgage, you control that.

Yeah.

The bank doesn't control it.

They're n- the bank is not
issuing a margin call to you

if they just feel like it.

And a margin call, just so everyone
knows, is essentially whoever you're

borrowing money from, in this case it
would be a, a brokerage firm, says,

"Hey, we lent you money to buy stocks.

We want our money back."

That's essentially what a margin call is.

There's thresholds and things like
that, but at the end of the day, that's,

that's simply what, what's going on here.

And so mortgage, you control.

Bank's not gonna pull your house
from underneath you, just doesn't

happen, even if it goes down.

Um, so you're in control
of that situation.

That's, that's ideal.

Margin, kind of the other extreme side
of this is, you're not really, right?

You borrow that money, that money
can be called effectively kind

of whenever they feel like it.

Now, that's a broad statement, but
more or less that, that's actually

what truly is, is the case with margin.

Then there's some s- things, especially
in our world, called a pledged asset line.

That's a little bit in, in the middle,
but, uh, it's just really important for

us when you're thinking about leverage.

This isn't just a simple black
and white, "Oh, all, all debt

is created equal," right?

It depends.

We're-- That's gonna
be the punchline- Yeah

of this whole entire episode.

Um, and you need to be
thoughtful around it.

And depending, kind of bringing it
back to what you were saying, and

then I'll give it back to you, is, um-
If you don't control the situation,

you should not get anywhere near
overextending or anywhere near the place

where there might be a margin call.

And I would even add to that,
you're introducing another fixed

expense to your priority stack.

And so all of these factors need
to be brought into, into the mix.

Okay, um, I don't want to sell
an asset because I don't want

to realize a taxable gain.

Well, um, can I, can I pull--
can I borrow against those

assets enough to fund my life?

But then what does that
do to me long term?

'Cause you never wanna have…

Uh, we highly recommend, I
shouldn't say never, never.

Never say never, right?

It's all situationally.

We highly recommend putting a
plan into place to have permanent

leverage, uh, you know, indefinitely.

There shou-should always be a, a plan
that-- to have that, that loan effectively

paid off at some point in time-

Mena Hanna: Yeah.

Yeah, just echoing what you said.

Sizing definitely matters, the window
of time matters, and then whether

or not you control your destiny,
that, that influences things.

I would say there's, there's also some
other tests that you can implement to

figure out kind of does this make sense.

Obviously, uh, in a lot of these cases,
for people that are taking on balance

sheet margin, they're not selling an
asset, and they're potentially taking a

short-term bridge loan, if you will, to,
you know, not incur those, those gains.

There's going to be a cost there.

What's your break even?

It's super important to understand
that, you know, even, even when

you take on debt, you're-- you
have to pay someone for it.

So what is the benefit between
paying someone else for it versus

potentially taking the tax hit?

The cushion test.

How much do markets have to fall or
how bad could potentially things get,

um, on, on the expense side too before
you're in a little bit of trouble?

I feel like I see a lot of people taking
on, taking on loans and debt for remodels.

They also start with, uh, a known, what
they think is a known amount on a remodel

that balloons to twice the initial amount.

If you didn't think about kind
of the cushion test in a proper,

proper way, you could inadvertently
really overextend yourself, like

you said, and put your portfolio
and, and potentially your balance

sheet in a, a real, real tough spot.

And then thinking about, yeah, the,
the true form of, of repayment and

how this is actually going to happen.

If you're doing this thoughtfully
and you know, hey, during X date, I'm

going to get this bonus, and this is
essentially just a loan that gets me

to that point, that's completely fine.

But as you said, taking on these loans
indefinitely just exposes you to a

million forms of, of risk, and I'll
use, I'll use a sports analogy here.

It's you just have to be
thoughtful in, in how you do this.

There's a whole camp of people that
say, "Hey, lifting weights is terrible

because there is a risk of getting hurt."

That is for sure true.

Lifting weights can also be good
for you if you build the right plan

structure in the right way, make sure
that you don't hurt yourself, and you

actually have a benefit if you do all
of those things in a proper fashion.

So it's, it's a much larger conversation.

That's kinda why you need a thought
partner in, in something like

this because it's something that
can ultimately help a portfolio,

help your, you know, your family's
balance sheet if done appropriately.

Justin Dyer: Yeah, one hundred percent.

Um, I think that's actually a great place
to wrap, and I'll, I'll wrap with a, you

know, a couple, couple summary comments.

One, I-I…

We're, we're gonna quote, um,
the good old Charlie Munger.

I, I said this a, uh, a while back,
but, uh, hi-his famous quote or infamous

quote around, around this topic was, uh,
"There's three ways a smart man can go

broke: liquor, ladies, and leverage."

And, um, then Warren Buffett, I,
I, I guess, said the first two were

only included 'cause they ha-have
an L, and e-essentially implying

leverage is exceptionally dangerous.

And at the end of the day, we said it a
couple times throughout this conversation,

it's situationally dependent, and I
really want people to walk away from that.

Leverage has the power to convert
volatility, especially when

we're talking about balance sheet
leverage, into permanent loss.

Full stop, right?

That is what Charlie Munger is saying
with respect to that, um, that comment,

and, uh, that is incredibly important
for everyone to, uh, to walk away

with, uh, from this conversation today.

So, uh, we'll, we'll end right there.

Hopefully, this is a, a quick
flyover, just, hey, it's complicated.

It's a tool.

It's a sharp tool.

Be careful with leverage.

There's a lot that needs to go into
whether or not it's the tool that you

should be using in support of your
journey towards that hundred-year family.

Definitely reach out with more
questions, talk to your advisor.

Uh, let us know if you have
additional questions on this topic.

Mino will give you

Mena Hanna: number.

Six two six-eight six two-zero three five

Justin Dyer: five.

And we love, we love the feedback.

We love commentary.

We love the questions,
so please keep them up.

Uh, we really appreciate you
all listening, and until next

time, own your wealth, make
an impact, and always be a pro