Stock Bubbles are Deflated by Ethnic Diversity

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In diverse company, people think more deeply, make better decisions, study finds

From The Great Depression through the dot-com boom of the 1990s to the recent financial crisis, stock market bubbles are a constant malaise. Even as bubbles devastate individuals and nations, preventing them has been difficult because their sources remain opaque.

A new study proposes a cause: Bubbles happen when people mindlessly trust the behavior of others, and they do so much more often when surrounded by ethnic peers. In an article published today in Proceedings of the National Academy of Sciences, researchers show that markets of ethnically diverse traders are much less likely to suffer bubbles. These findings could have a lasting impact on economics — and ethnic diversity.

“Ethnic diversity can bring a variety of perspectives, but is valuable also because it changes how people think, feel and behave.” says Dr. Sheen S. Levine of Columbia University who formed the research team of sociologists, economists, psychologists and business school professors.

Dr. David Stark, a Columbia sociologist and a member of the research team, says that “when surrounded by others who are ethnically the same, you behave differently – more likely to accept things at face value, less likely to scrutinize and think for yourself.”

Dr. Evan Apfelbaum, a social psychologist at the Massachusetts Institute of Technology and a member of the research team, adds, “With ethnic homogeneity, we place overdue confidence in others, just because they appear superficially similar to us.”

To study how ethnic diversity affects price bubbles, Dr. Levine and his collaborators constructed experimental markets in Southeast Asia and North America. It was a laboratory for bubbles: “We could pinpoint the true value of a stock, and compare these true values with market prices,” explains Dr. Mark Bernard, an economist at Goethe University in Frankfurt and a member of the research team. “So we could identify bubbles as soon as they appeared and measure their exact magnitude.”

The researchers randomly assigned participants, all versed in finance, to ethnically homogeneous or diverse markets, letting them trade stocks to earn cash. There were no initial differences between traders in homogenous and diverse markets. But when trading begun, a striking difference between the markets emerged.

Homogenous markets were much more likely to bubble. In them, overpricing was higher as traders were more likely to accept speculative prices. Their pricing errors were more correlated than in diverse markets. And when bubbles burst, homogenous markets crashed more severely. “Bubbles have been long ascribed to ‘herd behavior,’ ‘animal spirits’ and ‘thought viruses.’ but hard evidence has been scarce until now,” notes Dr. Edward J. Zajac, a Northwestern University professor and another researcher on the study. Across markets and locations, market prices fit true values 58 percent better in diverse markets.

“Our first results came from research sites in Southeast Asia, involving Chinese, Indians, and Malay traders,” says Dr. Valerie Bartelt, a professor at Texas A&M-Kingsville and a research team member. “We wanted to verify that the results hold in a different culture.” The researchers proceeded to replicate the study in the United States with White, African-American and Latino traders. The findings were similar to those from Southeast Asia, despite sizeable differences in culture and ethnic composition. This suggests a universal pattern.

What is the practical significance of the findings? A recent study by CUNY’s Center for Urban Research found that more than half of Wall Street’s workforce was made up of white men, who earned more than twice as much as women and minorities. In the financial center of London, diversity may be even less, suggest data from Astbury Marsden, a recruiting firm.

“Our findings are another compelling reason to diversify markets, teams, boards, and organizations,” concludes Dr. Levine.

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