Give ’em Enough Rope? Leveraged Trading when Investors are Overconfident

Can leverage constraints mitigate overconfident financial decision-making? I examine CFTC regulation capping the maximum permissible leverage available to U.S. households that trade foreign exchange on the same brokerages as similar but unregulated European traders. The constraint reduces trading volume and alleviates up to three-quarters of per-trade losses. According to a model of portfolio choice with distorted beliefs, investor overconfidence can explain both leverage demand and underperformance. Several tests support the predictions of the model. Using common proxies to classify traders as overconfident, I find that these traders are most affected by the regulation. Consistent with overconfident, belief-based trading, traders ignore CFTC warnings of leveraged trading risks.