Investing is ultimately about risk and reward. And margin trading turbocharges that dynamic. Leverage, however, cuts both ways.
“Leverage on the way up is a great thing. Leverage on the way down can rip your arms off,” former CEO of TD Ameritrade Joe Moglia recently warned when discussing meme stocks.
A new academic study on margin trading revealed which types of retail investors appear most likely to lose an arm — or two.
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“Our findings show that investors with higher investment literacy are less likely to buy on margin, while investors with higher overconfidence in investment literacy are more likely to buy on margin, and that risk tolerance is positively related to the likelihood of buying on margin,” wrote three professors in a paper titled, “The Effect of Investment Literacy on the Likelihood of Retail Investor Margin Trading and Having a Margin Call.”
The authors claim their paper provides “new insights” into the impact of investment literacy, overconfidence in one’s perceived financial literacy, and age on margin purchases and the likelihood of facing a margin call.
The study determined that increased margin activity correlates with youth and that investors with greater objective financial literacy are more likely to have well-diversified portfolios.
“The likelihood of buying on margin decreased with age and increased with risk tolerance and with the amount of investment assets,” wrote the professors, who are affiliated with the Seoul School of Integrated Sciences and Technologies, the University of Alabama, and Ohio State University.
The study was based on 1,215 U.S. retail investors who completed the 2018 National Financial Capability Study (NFCS) main survey and answered questions associated with margin trading in that year’s NFCS Investor Survey.
The investment survey asked respondents eleven questions to gauge their investment literacy. Topics included stocks, bonds, bankruptcy, investment risk, investment returns, municipal bonds, stock margin, selling short, investment indicators, index funds, and call options.
Under U.S. margin trading rules, investors can borrow up to 50% of the purchase price of most securities from a brokerage firm, effectively enabling 2:1 leverage.
Greg Bartalos (@gregorianchance) is editor of New York City-based RIA Intel.