Biased By Choice: How Access to Leverage Exacerbates Financial Mistakes
54 Pages Posted: 29 Dec 2018 Last revised: 20 Mar 2020
Date Written: December 13, 2018
According to standard theories of decision-making, access to leverage should make investors better off. The ability to borrow expands investors' choice sets, allowing them to take advantage of trading opportunities without having to liquidate current holdings. This paper argues that leverage can interact with existing behavioral biases -- specifically, the reluctance to realize losses -- to impair decision-making and hurt performance. Two data sources provide support for this claim. First, we exploit regulation that restricts the amount of leverage available to U.S. retail traders of foreign exchange. Traders constrained by the regulation are more willing to realize losses, exhibiting a smaller disposition effect, and improve their market timing. We replicate these findings in an experimental asset market. Access to leverage leads to significantly lower earnings. This decrease in performance is driven by levered participants holding on to losses for longer, deviating further from an optimal trading strategy than those without access to leverage. Together, our findings imply more choice may not always be better than less and suggest scope for policy to improve financial decision-making.
Keywords: Loss Chasing, Disposition Effect, Prospect Theory, Behavioral Finance
JEL Classification: G02, G11, D03, D18
Suggested Citation: Suggested Citation