Investor attention and the use of leverage

• Published date: 01 May 2023
• Author: Denis Davydov,Jarkko Peltomäki
• Date: 01 May 2023
• DOI: http://doi.org/10.1111/fire.12337

DOI: 10.1111/fire.12337

ORIGINAL ARTICLE

Investor attention and the use of leverage

Denis Davydov1Jarkko Peltomäki2

1HankenSchool of Economics, Helsinki,

Finland

2Stockholm Business School, Stockholm

University, Stockholm, Sweden

Correspondence

JarkkoPeltomäki, Stockholm Business School,

Stockholm University,SE-10691, Stockholm,

Sweden.

Email: jape@sbs.su.se

Fundinginformation

Finnish Foundationfor Share Promotion, Jan

Wallanderand Tom Hedelius Foundation and

ToreBrowaldh Foundation, Grant/Award

Number: P20-0101

Abstract

We investigate the effects of using different sources of

investmentleverage, that is, securities with embedded lever-

age and traditional margin accounts, on the portfolio per-

formance of retail investors, recognizing that these effects

may be conditional on investor attention. We find that

investors who trade on margin underperform those who do

not have margin accounts; we also find that investors trad-

ing securities with embedded leverage show even poorer

performance than investors trading on margin. The negative

effect of leverage usage, however, decreases with greater

investor attention, measured by portfolio monitoring fre-

quency. Results suggest that more attentive investors gain

more from using investment leverage.

KEYWORDS

embedded leverage,investment leverage, investor attention, margin

trading, portfolio performance

JEL CLASSIFICATION

G11, G29, G40

1INTRODUCTION

Financial leveragehas been extensively used by investors to amplify the anticipated benefits from stock price fluctua-

tions. It enables arbitrageursand informed traders to exploit opportunities in mispriced securities while their activities

should presumably contribute to market efficiency.Hence, it is not surprising that the appetite for financial leverage

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in anymedium, provided the original work is properly cited.

© 2023 The Authors. The Financial Review published by WileyPeriodicals LLC on behalf of Eastern Finance Association.

Financial Review. 2023;58:287–313. wileyonlinelibrary.com/journal/fire 287

288 DAVYDOV AND PELTOMÄKI

has recently broken a new record with margin debt reaching an all-time high in the United States and elsewhere.1

Such remarkable growth can be also partly attributed to the ease of access to financial leverage via the evolvingtrad-

ing platforms for retail investors such as “Robinhood.” The ready availability of margin debt on favorable terms2for

investors on Robinhood has resulted in an astonishing increase in the amount of Robinhood’s margin lending, which

grew by more than five times during 2020 alone.3Clearly, such growth is associated with the increased riskiness of

retail investors’ portfolios, which mayaffect their overall performance.

While margin debt is subject to certain regulatory requirements and limitations that put some constraints on mar-

gin use, the recent developments in financial instruments have allowed investors to alleviate these constraints by

investing in widely available leverage-embedded securities such as Exchange Traded Funds (ETFs) or Certificates.

These securities sometimes increase market exposure by up to 20 times and limit potential losses to 100% without

the need to actively rebalance leveraged positions. The attractiveness of these features may be tempting for retail

investors even if they are unable or unwilling to use outright margin debt. However, recent empirical studies show

that retail investors often perform poorly when they tradewith leverage (see e.g., Barber et al., 2020; Heimer & Imas,

2022). Such findings have important regulatory implications for the protection of retail investors.This study explores

one potential mechanism to explain the variation in the performance of levered retail trading: the role of investor

attention.

In this paper,we first explore the determinants of usage of different sources of leverage, that is, embedded leverage

securities and traditional margin accounts, in a rich and unique dataset on retail investors.Next, we assess the effects

of leverage on portfolio performance, accounting for investor-specific characteristics and for differences in trading

behavior. A growing body of research suggests that leverage maycontribute to poorer trading decisions caused by

behavioral bias (see e.g., Bailey et al., 2019; Barber et al., 2020;Ben-David,2019; Heimer & Imas, 2022). Another

stream of the literature suggests that investors make better investment decisions by payingmore attention and by

acquiring more information (e.g., Gargano & Rossi, 2018; Peress, 2004). Dierick et al. (2019), for instance, suggest

that more attentive investors gain a comparativeadvantage from understanding and incorporating financial informa-

tion into their investment decisions. As a result, these investors’trading is increasingly less exposed to the disposition

effect. Thus, if more attentive investors can process financial information better,they should be able to benefit from

employing leveragein their investment decisions, regardless of the behavioral bias associated with the usage of lever-

age. Building on these two strands of literature, we empirically test whether the joint effect of investor attention

and the use of leverage has a positive effect on portfolio performance. Our main objective is to assess whether the

impact of using margin accounts and instruments with embedded leverage on investmentperformance is conditional

on portfolio monitoring frequency.

In line with the recent evidenceof Heimer and Imas ( 2022),and Barber et al. (2020), we find that the use of leverage

in any form, through the margin account or securities with embedded leverage, is associated with poorer investment

performance. However,we also find that investors are better off trading on margin compared to trading securities with

embedded leverage. This finding is consistent with Frazzini and Pedersen (2014, 2022), who suggest that leverage-

constrained investors underperform on average. The observed difference in performance between the users of the

two sources of leverage also adds to previous findings that connect the use of investment leverage with a lack of

investor patience (Cremers & Pareek, 2016) and self-control (Uhr et al., 2019). Finally, our main results show that

more attentive investors are better users of leveragecompared to less attentive ones. However, this finding does not

apply to the most aggressive traders of embedded leveragesecurities.

We contribute to the previous literaturein the following ways: first, we differentiate between investors who trade

on margin and those who use securities with embedded leverage. Tothe best of our knowledge, none of the previous

1As of February 2021, US investorshad borrowed over $813 billion, which is almost 50% more than the year before, according to the Financial Industry

RegulatoryAuthority (FINRA)https://www.finra.org/investors/learn-to-invest/advanced- investing/margin-statistics

2Asof March 2021, investors on Robinhood could borrow up to $1000 for just $5 a month and 2.5% for anything above $1000.

3According to the company’s filing with the SEC, Robinhood’s net margin loans to their customers increased from approximately $638 million in 2019 to

$3.35billion in 2020 https://www.sec.gov/edgar/browse/?CIK=1699855