Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes

Abstract

We show that constraints can improve financial decision-making by disciplining behavioral biases. In financial markets, restrictions on leverage limit traders’ ability to borrow to open new positions. We demonstrate that regulation that restricts the provision of leverage to retail traders improves trading performance. By increasing the opportunity cost of postponing the realization of losses, leverage constraints improve traders' market timing and reduce their disposition effect. We replicate these findings in two distinct experimental settings, further isolating the mechanism and demonstrating generality of the results. The interaction between constraints and behavioral biases has implications for policy and choice architecture.

The potential built‐in supply effect from margin trading in the Chinese stock market

“…The increase in activity by U.S. retail traders who have easy access to margin loans is likely to affect the implications for margin trading on price dynamics. Given the similar behavioral bias exhibited by retail margin traders in both the Chinese and U.S. markets (Bian et al., 2021; Heimer & Imas, 2021), our findings enhance the understanding of the impact of margin trading on price efficiency around corporate events by market participants and policy makers, both in China and the United States. For instance, margin traders may consider any unintentionally aligned action with other margin traders when covering their positions around salient events.…”

“…In addition, Heimer and Imas (2021) document that retail investors in the United States applying leverage are more inclined to exhibit the disposition effect. The disposition effect and its impact on pricing efficiency are well‐documented in both the Chinese (Liu et al., 2021) and U.S. financial markets (Heimer & Imas, 2021; Shefrin & Statman, 1985). However, it is difficult to investigate the impact of retail margin trading in the United States due to limited data availability.…”

“…The proposed trading patterns and the related behavioral bias are more likely to occur among retail margin traders, who are known to perform poorly and less rationally (Bian et al., 2021; Davydov & Peltomaki, 2021; Heimer & Imas, 2021). Therefore, we test our hypotheses by utilizing the unique daily margin interest and covering data of the Chinese stock market, which is dominated by retail investors and where almost all margin traders are retail (China Security Journal, 2016).…”

“…In the same Chinese setting as ours, Bian et al (2021) find that margin traders exit their brokerage loan position by selling their shares and repaying the amount, rather than injecting additional cash to pay off the loan and keep the shares. Imas, 2021). Therefore, we test our hypotheses by utilizing the unique daily margin interest and covering data of the Chinese stock market, which is dominated by retail investors and where almost all margin traders are retail (China Security Journal, 2016).…”

Taxing the Disposition Effect: The Impact of Tax Awareness on Investor Behavior

“…Frydman, Hartzmark, and Solomon (2018) find that the disposition effect is lower when investors immediately reinvest the proceeds of the stock sale, highlighting the importance of capital constraints in limiting suboptimal behavior. Heimer and Imas (2021) find that leverage restrictions reduce the disposition effect by making it more costly for investors to hold on to losing positions. Our experiment manipulates the salience of another important financial friction: capital gains taxes.…”