Does leverage improve performance?

One of the most controversial actions in finance is to use leverage. Leverage acts as a magnifier both good and bad. If you invest in something profitable, your profits will be boosted, if you invest in a losing asset, well, good luck to you.

And that’s the problem as a study of Chinese institutional and individual investors has shown. The study looked at the trading performance of a futures brokerage in China offering its services to both institutional and individual investors. There’s a lot of interesting information in that study, but the key message is shown in the chart below:

Net profit by percentile

Source: Subrahmanyam et al. (2021)

The majority of investors lose money. For institutional investors, the median profit after fees is not a profit at all but a loss of 19,000 Yuan ($2,973). For individual investors, it is a somewhat smaller loss of 14,000 Yuan ($2,191). Individual investors lose not because they are better investors, but because their trades are smaller. The median loss per unit of investment is the same. However, individual investors seem to lose that money faster than institutions since the median length of a trade for individual investors is a mere 49 minutes compared to about one trading day for institutions.

But never mind the small differences between institutional and individual investors. The driver behind the fact that the majority of investors lose money with leveraged investors seems to be the same in both cases. First, by using leverage, investors increase the notional value of their investments and thus the transaction costs of their investments. Second, and most importantly, leverage amplifies the disposition effect, that is our natural tendency to sell winners too soon and hold on to losing investment for too long. In laboratory experiments, it has already been shown that his tendency to hang on to losers too long leads to increased losses that get amplified when leverage is involved. Now we have evidence that the same effect is true in real life. 

Mind you a small group of investors (both institutional and individual) is able to use leverage profitably, but these are the ones who either got lucky or have managed to get their disposition effect under control through disciplined investment techniques like the ones I have described here. In the end, it boils down to a matter of discipline and sophistication. If you think you are disciplined enough to use leverage, by all means, go ahead, but know that human nature has stacked the odds against you.