Can Ethnic Diversity Prevent Financial Bubbles?

It’s no wonder researchers are fascinated by financial bubbles. For one thing, bubbles demonstrate humanity at its most feverishly irrational; for another, they have devastating real-world consequences when they pop. Much of the research dedicated to this phenomenon is motivated by a desire to figure out ways to prevent bubbles from inflating in the first place, and a new study (if the link isnt public yet, it will be shortly) in Proceedings of the National Academy of Sciences offers an intriguing hint: When a group of investors is diverse, bubbles may be less likely to form.

As the researchers, led by professors at Columbia and MITs Sloan School of Management, point out, “ethnic diversity facilitates friction.” This is obviously bad in certain contexts, sometimes to the point of contributing to deadly violence. But when it comes to financial bubbles, the authors argue, there are reasons to think it could be a good thing: In such settings, they write, “vigilant skepticism is beneficial; overreliance on others’ decisions is risky.”

That is, if the participants in a market are too similar and they have too much faith in one another’s decisions (“My buddy over there is investing in mortgage-backed securities, so I should, too!”), it could potentially help foster the sort of irrational exuberance that inflates bubbles. On the other hand, since a large body of past work suggests that people process information less superficially in diverse settings and are generally more skeptical and thoughtful in their decision-making when surrounded by people dissimilar to them, diversity could act as an important bubble-buffer for markets.

To test this idea, the researchers recruited participants with some degree of finance know-how into two stock-market simulations — one in North America and one in Southeast Asia. Some were assigned to diverse groups, others to homogeneous ones. As the researchers predicted, homogeneous markets were both more susceptible to bubbles and less adept at pricing the simulations’ assets accurately. In these markets, when people made errors by, say, overvaluing an asset, that error wasn’t corrected by someone being off in the other direction (one of the benefits of aggregating the opinions of a group), but was rather exacerbated. Everyone decided at the same time that tulips were all the rage, in other words. In the diverse markets, there was more skepticism and therefore less air for potential bubbles.

This was just one experiment, of course, and it involved virtual markets rather than real ones. But it still loudly hints at some important advantages of diversity — advantages that sit comfortably in line with previous research. “Ethnic diversity was valuable not necessarily because minority traders contributed unique information or skills, but their mere presence changed the tenor of decision-making among all traders,” the researchers write. “Diversity benefited the market.”