Leverage and the disposition effect
Employing leverage in your investments can be a good thing. The path towards the upper middle class in industrialised countries is paved with mortgages and university diplomas. Buying a house with leverage (i.e. a mortgage) allows people in the UK and elsewhere to not only get a home but to build substantial wealth over time by paying down the mortgage. Once retried, the house in the city or the suburbs can be sold in favour of a smaller home in the countryside. Surplus equity then makes for a nice nest egg. Similarly, student debt enables young people in the US to finance a university degree that leads to higher lifetime income through better-paid jobs (that is, of course, if you do not study critical philosophy as my wife did…).
In the world of investments, there are some examples when the use of leverage can lead to systematically better performance. Some listed investment companies in the equity and fixed income space outperform their open-ended peers or a traditional stock market benchmark thanks to their ability to employ leverage in the fund.
But the path to ruin is paved with excessive leverage. Employ leverage in your investments and losses get amplified as well. Employ too much leverage and you don’t have to worry about recovering your losses anymore because you lost all your money and there is no coming back from that loss.
In a new study, Rawley Heimer of Boston College and Alex Imas of Carnegie Mellon University investigated how currency traders behaved in different environments. They exploit a 2010 regulatory change in US forex markets that forced brokers to limit the leverage their US customers employed to 50:1. European customers at these brokerage firms were not subject to this regulation and could employ the leverage limits the brokerage houses deemed appropriate, which were generally much higher than 50:1. Thus, European retail traders and US retail traders invested in the US currency futures markets with different degrees of leverage.
What the study showed was that the investors with higher leverage tended to do worse than the investors with lower leverage, even when the returns are corrected for other differences between the two sets of traders. The driver behind this lower performance with higher leverage were not declining prices, since profits remained positive for both groups of traders. Instead, the traders that were able to employ higher leverage were more reluctant to cut their losses. If your leverage is restricted, there comes a point when a trader must close a losing position in order to enter a new one. If leverage is unrestricted, one can simply increase leverage and enter a new position without closing existing ones. And since there is overwhelming evidence that the disposition effect (i.e. the reluctance to close losing positions and a tendency to realise gains too soon) has significantly negative effects on performance, restricting leverage acts like a check on the disposition effect and improves performance.
It is like a bank forcing prospective homeowners to have at least 20% equity in their newly purchased home. We all know how it ends, if banks waive this requirement and allow investors to increase their leverage to 100% of the value of the newly purchased home…
The effect of leverage on returns in currency trading
Source: Heimer and Imas (2018).