University of Warwick-led study shows that markets of ethnically diverse traders are much less likely to suffer bubbles

Coventry, UK, 20-11-2014 — /EuropaWire/ — 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 behaviour of others, and they do so much more often when surrounded by ethnic peers. In an article published yesterday (17 November) in Proceedings of the National Academy of Sciences, researchers led by David Stark from the University of Warwick in the UK and Columbia University and Columbia University’s Sheen Levine show that markets of ethnically diverse traders are much less likely to suffer bubbles.

When surrounded by others who are ethnically the same, traders are more likely to accept things at face value and less likely to scrutinize.

To study how ethnic diversity affects price bubbles, the researchers constructed experimental securities markets in Southeast Asia and North America. It was a laboratory for bubbles. They could pinpoint the true value of a stock, and compare true values with market prices. So they 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 markets or ethnically diverse markets, letting them trade stocks to earn cash. There were no initial differences between traders in ethnically homogeneous markets and ethnically 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.

Across markets and locations, market prices fit true values 58 percent better in diverse markets.

The researchers’ first results came from research sites in Singapore. Next, they wanted to verify that the results hold in a different culture, so they replicated the study in the U.S. The findings were similar to those from Singapore, despite sizeable differences in culture and ethnic composition.

What is the practical significance of the findings in light of the fact that many trading environments, including Wall Street, are not very ethnically diverse?

Alongside any moral value from ethnic diversity, there are efficiency gains from ethnic diversity.

Contact:

David Stark, d.stark@warwic.ac.uk, +1 917-697-0199, Skype: davidstark361.

Lee Page, Communications Manager, Press and Policy Office, The University of Warwick. Tel: +44 (0)2476 574 255, Mob: +44 (0)7920 531 221. Email: l.page@warwick.ac.uk.

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David Stark