The Financial Illiteracy and Overconfidence of Margin Traders
March 6, 2018
K. Jeremy Ko and Steven Rapkin
We use survey data from 2015 to examine the financial literacy and other characteristics of US investors with non-retirement investment accounts (both advised and self-directed) – focusing on investors who have margin approval from their brokerages or margin-trading experience (i.e., investors who have ever purchased securities on margin). We find that, on average, investors who trade using margin have lower financial literacy and understand margin trading less well than those who do not trade using margin (either because they do not have margin approval or because they choose not to borrow in margin-approved accounts). Notably, only 15% of margin traders could answer a basic question about margin correctly, compared to 31% of non-margin traders. Further analysis reveals that, on average, investors with margin-trading experience and approval have higher risk tolerance and confidence in their investment knowledge than those without. Overconfidence in investment knowledge appears to be a key element in explaining why lower-literacy traders gravitate toward margin. Our findings also suggest the need for additional research to study whether these findings generalize to other leveraged instruments or strategies.