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Ethnic Diversity Deflates Market Bubbles

But it's not in the rainbow and sing-along way you'd hope for. We just don't trust outsiders' judgments.
(Photo: petrick/Flickr)

(Photo: petrick/Flickr)

Ethnic diversity could help prevent stock market and housing bubbles, according to new experiments, though the reason might be a little bit depressing. Basically, we’re less likely to trust others’ judgment‚ and therefore less likely to follow their leads, when they come from different ethnic groups than our own.

That’s the conclusion of a paper just out in Proceedings of the National Academy of Sciences that reports the results of two stock-trading experiments conducted in Singapore and Kingsville, Texas. The project was motivated in part by a desire to understand how the housing bubble followed so closely on the heels of the 1990s tech bubble, lead author and Columbia University economist Sheen Levine writes in an email. “In 1999, everybody I knew was starting an Internet company, and in 2005 the same people assured me that real estate prices can only go up,” he says. “I wondered how intelligent people, versed in economics and finance, can all ignore reality so well.”

"I wondered how intelligent people, versed in economics and finance, can all ignore reality so well."

One hypothesis is a kind of groupthink. If somebody’s buying one stock and I'm not, the groupthink goes, he must know something I don’t, and I should follow suit—while in truth the buyer might actually need a reality check.

Ethnic diversity, some suggest, could be a solution to this conundrum. University presidents have defended programs aimed at racial and ethnic minorities on those grounds, and research seems to back up the idea that a wider range of viewpoints leads to more balanced, groupthink-free decisions. Yet ethnic diversity has a dark side too, Levine and co-authors point out. Sometimes, it leads to more conflict than progress.

To see whether diversity could improve stock-market decisions—and if so, why—the researchers divided 180 people with backgrounds in business or finance into groups of six. Those groups played a 10-round stock-market game in which players traded a dividend-paying stock. Half the groups were ethnically homogeneous, while the other half had at least one ethnic minority—say, five Chinese players and one ethnically Malay player. While traders knew the ethnic make-up of their groups, they couldn’t communicate with each other, and all trades were anonymous.

As expected, homogeneous groups set inflated selling prices, yet traders in those groups still bought the stock, and the stock price climbed over 10 rounds. Just the opposite happened in ethnically diverse groups: Traders refused inflated selling prices, and over time the stock price fell to roughly the price it would have in an idealized market with rational traders.

It would have been nice if that had happened because traders in diverse groups took others' views into account when setting prices, but with anonymity and a lack of communication, it’s more likely they simply didn’t trust others’ judgments when it came to setting reasonable buying and selling prices.

“Homogeneity, we suggest, imbues people with false confidence in the judgment of coethnics, discouraging them from scrutinizing behavior,” the authors write.