We usually think of ethnic diversity as a matter of social policy, not a factor that could impede market bubbles. But new research by me and a team of colleagues suggests a surprising new reason to consider diversity as a hedge against speculative bubbles: in two studies, we find that markets comprised of ethnically diverse traders are more accurate in pricing assets than ethnically homogeneous ones. Our paper, which came out Nov. 17 in Proceedings of the National Academy of Sciences (PNAS), finds that ethnic diversity leads all traders, whether of majority or minority ethnicity, to price more accurately and thwart bubbles. The reason isn’t because minority traders had special information or differential skills; rather, their mere presence changed how everyone approached decision-making. Traders were more apt to carefully scrutinize others’ transactions and less likely to copy others’ errors in diverse markets, and this reduced the incidence of bubbles.
To conduct our research, we constructed experimental markets in the United States and Singapore in which participants traded stocks to earn real money. We randomly assigned participants to ethnically homogenous or diverse markets. We found that markets comprised of diverse traders did a 58 percent better job at pricing assets to their true value. Overpricing was higher in homogenous markets because traders are more likely to accept speculative prices, we found. Their pricing errors were more correlated than in diverse markets. And when bubbles burst, homogenous markets crashed more severely.
The effects were not driven by differences in financial pricing skills of diverse versus homogeneous markets. Rather, the findings highlight the power of social context in which trading decisions are made. And while pricing errors were preserved or even exacerbated in homogenous markets, accuracy improved in diverse markets. But the paper speaks more to the perils of homogeneity than to the virtues of diversity. The most prominent effect is not the increase in accuracy in diversity markets; it’s the sizeable decrease in accuracy in homogeneous ones.
Past work has argued that diversity fuels conflict and makes people uncomfortable. It is clear that people work harder in diverse settings, socially and cognitively. So when it comes to creating the conditions that promote cold hard accuracy in decision-making, diversity may be an invaluable asset.
Evan Apfelbaum is the W. Maurice Young (1961) Career Development Professor of Management and an Assistant Professor of Organization Studies at the MIT Sloan School of Management.