Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes

Heimer, Rawley Z.; Imas, Alex

doi:10.1093/rfs/hhab073

Review of Financial Studies 35 (4): 1643–1681

Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes

Rawley Z. Heimer and Alex Imas

RFS Rising Scholar Award.

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.

Keywords: leverage constraints, disposition effect, behavioral biases, retail traders, financial regulation, choice architecture, experiments.

JEL codes: D18, D91, G11, G40, G41, G50.

In brief

Limits on borrowing can make investors better off by curbing their behavioral biases.

Studying a regulation that restricted how much leverage retail traders could use, the paper finds that constrained traders had better market timing and a weaker disposition effect — the tendency to sell winners too soon and hold on to losers. The mechanism is opportunity cost: when borrowing is limited, keeping a losing position open ties up capital that could fund new trades, so putting off a loss becomes more expensive. Two separate experiments reproduce the result, suggesting that well-designed constraints can work as a form of choice architecture.

**Table 1.** Study at a glance
Panel A. Design
Question	Can limits on borrowing reduce investors’ behavioral biases?
Setting	A regulation restricting the leverage available to retail traders
Data	Retail trading records and two experimental settings
Method	Trading before and after the leverage restriction; replication in two experiments
Panel B. Main findings
Trading performance	Improves under leverage constraints
Market timing	Improves
Disposition effect	Declines
Mechanism	Constraints raise the opportunity cost of postponing realized losses

Summarized from the paper. See the paper for exact estimates and specifications.

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Published version, Review of Financial Studies
Working paper version, SSRN
DOI: 10.1093/rfs/hhab073

Heimer, Rawley Z., and Alex Imas. 2022. “Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes.” Review of Financial Studies 35 (4): 1643–1681. https://doi.org/10.1093/rfs/hhab073.

@article{heimer2022biased,
  author  = {Heimer, Rawley Z. and Imas, Alex},
  title   = {Biased by Choice: How Financial Constraints Can Reduce Financial Mistakes},
  journal = {Review of Financial Studies},
  volume  = {35},
  number  = {4},
  pages   = {1643--1681},
  year    = {2022},
  doi     = {10.1093/rfs/hhab073},
  url     = {https://academic.oup.com/rfs/article/35/4/1643/6308957}
}

Topics: Retail investing and brokerage; Behavioral finance and beliefs; Consumer protection and financial regulation
Related papers: Dynamic Inconsistency in Risky Choice: Evidence from the Lab and Field; Should Retail Investors’ Leverage Be Limited?; Peer Pressure: Social Interaction and the Disposition Effect; Friends Do Let Friends Buy Stocks Actively

In brief

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