Archimedes was a Greek mathematician, physicist and inventor born sometime around 287 B.C. in the Greek colony of Syracuse in Sicily. He is known to this day for his statement: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” The concept of leverage can, of course, be measured with some precision in the physical world, and it is a powerful concept.
But Archimedes never worked on Wall Street, and he wouldn’t recognize what today’s inventors of financial products are doing in the name of leverage. Leverage in the financial world can lead to astonishing success … or a crushing collapse.
Financial leverage
No academic has ever explained the use of financial leverage better than actress Selena Gomez in the movie The Big Short, with a great assist from behavioral economist Richard H. Thaler. In three minutes, these two explain financial leverage in a way anyone can understand. Once you watch that scene, you will want to see the entire exceptional movie and also read the book it’s based on, The Big Short: Inside the Doomsday Machine by Michael Lewis. The book and movie chronicle the collapse of the housing market and related securities that led to the crash of 2008. Why the crash? Leverage run amok.
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On to bitcoin
So how is leverage rearing its head on Wall Street today? If your answer is “a bet on bitcoin,” the crown jewel of the cryptocurrency universe, you win. Let’s explore how investors are using leverage to invest in bitcoin. Perhaps Archimedes would advise that leverage works best when one stands on solid ground instead of assets that exist in a cloud.
To proceed step by leveraged step:
First, bitcoin itself. It is an asset with no physical presence, no government backing and a value set by an active and very volatile market. You could simply buy a bitcoin or a fraction of one. This can be done, amazingly enough, at grocery store vending machines. But that is only the beginning.
Second, enter a company called MicroStrategy (MSTR). It buys bitcoin, borrowing a substantial portion of the purchase price, a classic use of leverage when one expects the asset purchased to rise. The company then issues more equity shares, selling those shares to investors like … you. And uses the proceeds of the sale of the shares to … purchase more bitcoin. And then it repeats the whole process. MicroStrategy holds about $41 billion in the cryptocurrency. Since it is the bright shiny thing on Wall Street at the moment, investors have pushed up the market value of the company’s stock to $91 billion. People who got in early on MicroStrategy have made extraordinary returns. The obvious question is whether the market value of the stock is sustainable in light of the value of the bitcoin the company owns.
Third, there are “single stock exchange-traded funds,” such as Tuttle Capital Management and Defiance, which seek to offer double the daily return on MicroStrategy stock by using complex derivative contracts, such as instruments known as total return swaps, and options. Thus, another lever. Archimedes would certainly ask if these levers are long enough for the exchange-traded funds (ETFs) to accomplish their goals.
Each of the corporate entities discussed here has made lawyers wealthy drafting the appropriate disclaimers and warnings about volatility, the novelty of the process, regulatory uncertainty about what a bitcoin really is and who should regulate it. One would be wise to actually read those warnings.
You’ve read the warnings and still want to get in the game
Enough about warnings. Enough about risk. You want to get in the game. Fair enough. I would urge you to do so in a fashion that doesn’t make you the poster child for those who put all of their money into this relatively new and exciting investment class and end up living on a friend’s couch when/as/if the bitcoin market has a major correction. So how to get involved before somebody else makes all the money while you are sitting on the sideline? Six considerations:
- Make sure your basic financial life is in order (I am a devotee of The Only Investment Guide You’ll Ever Need by Andrew Tobias).
- Don’t buy anything on a cold call. These people are seeking to make money for themselves, not you, but they can be charming, convincing and, eventually, ruthless.
- Educate yourself. You should never buy a financial product if you don’t have at least a passing idea of what it involves. Be able to explain the investment to someone else. And the one fact you should absolutely understand in this conversation is that leverage works both ways: It does indeed magnify gains, but it also magnifies losses.
- Don’t cross-collateralize your conventional financial assets with bitcoin or any other cryptocurrency. If you don’t understand the preceding sentence, please see the third bullet, above.
- In an account unrelated to your other financial assets, at a separate financial intermediary, put no more than 5% of your liquid assets into the speculative investment you’ve chosen. This should be money you can afford to lose.
- Don’t become obsessed with any investment. Don’t let it take over your life. If your bitcoin investment goes up, be pleased, but consider if you should take your profits, keeping in mind the capital gains tax consequences. If it goes down, consider it the price of an education.
Either way, go outside and watch a few kids play on a seesaw. It is a perfect example of balance and leverage. Archimedes would be pleased.
For more on this topic, see the follow-up to this article, Financial Leverage, Part Two: Don't Say We Didn't Warn You.
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