Columbia University

Faculty of Arts and Sciences

How Diversity Deflates Price Bubbles

November 17, 2014

David Stark and Sheen Levine have discovered an interesting thing about financial bubbles: there’s a trick to deflating them and it has to do with diversity. 

Where other means have failed at stemming the growth of financial bubbles, it turns out that in a diverse market, traders scrutinize a sale more, less likely to accept a price that may be inflated. In a homogenous market, traders trust more, setting the stage to pay more than what the true value is based off a kind of herd mentality. 

It’s an important finding they’ve explored in their recent work, “Ethnic Diversity Deflates Price Bubbles,” that was published today in the Proceedings of the National Academy of Sciences.

They set out to test their idea in two markets, one in Southeast Asia and the other in North America, and what they found was surprising: market prices fit true values 58% better in diverse markets.

Their work has significant implications not just for financial markets but for the workplace in general. What follows below is a Q&A on their work:

You describe markets as homogenous and diverse. What do you mean by this? What effect does the homogeneity or diversity of a trading community have on market prices/pricing?

David Stark: Several years ago, I heard Sheen present a paper at a conference in Berlin.  He had found (consistent with similar research by the Nobel Laureat economist Norman Smith) that participants in a lab experiment would sometimes misprice assets leading to a market bubble. I had just completed my book, The Sense of Dissonance: Accounts of Worth in Economic Life (Princeton University Press), which makes a case for the value of dissonance.  I asked Sheen if researchers had ever tried to alter the composition of the traders in the experiment. When we learned that this had not been attempted, we knew we had an opportunity to bring sociological insights to the understanding of market behavior.  

Sheen Levine: "Homogeneity" and "diversity" can mean different things for different people. We examined the effects of ethnic diversity, the extent to which people differ in their ethnicity. For instance, in North America, a homogenous market would be composed exclusively of White traders, whereas a diverse market would include at least one trader who’s Black (or Latino or Chinese). We find that the ethnic makeup of traders in the market has a pronounced effect on prices — and price bubbles, which occur when market prices rise above true values.

Across markets and locations, market prices fit true values 58% better in diverse markets. The effect is similar in Southeast Asia and North America, despite sizeable differences in culture and ethnic composition. Specifically, in homogenous markets, overpricing is higher as traders are more likely to accept speculative prices. Their pricing errors are more correlated than in diverse markets. And when bubbles burst, homogenous markets crash more severely.

In an ethnically diverse market, do business collaborators receive more or less scrutiny?

SL: In diverse market, we tend to scrutinize others' decisions; in homogenous company, we tend to place undue confidence in others' decisions. In a market, that means that we view other people's decisions as reasonable, even when they're not. This undue confidence eases people into imitatating others’ behavior.

Are diverse trading communities better at enacting price structures than financial regulations or policies? 

SL: Markets are central to our lives. We rely on them not only to furnish necessities, but also to finance businesses, provide healthcare, control pollution, and predict events. The market has become such a central social institution because it typically excels in aggregating information and expectations from disparate traders, thereby setting prices and allocating resources better than any individual or government.

Markets work when people compete. When people start imitating one another, markets fail. This is where bubbles come from: Traders imitating one another’s mistakes rather than ignoring (or taking advantage of) them. Bubbles can be devastating, but preventing them is difficult because no regulation can stop people from aping stupid behavior.

Our findings suggest that ethnic diversity in the market makes traders more vigilant, more likely to scrutinize other people's behavior, less likely to mindlessly imitate.

DS: Prior to this research using laboratory experiments, I had conducted an ethnography of a Wall Street trading room with my former student Daniel Beunza (now at the London Business School). Part of our research involved the study of the merger arbitrage desk, published as "From Dissonance to Resonance: Cognitive Interdependence in Quantitative Finance" in the journal, Economy and Society. That merger arbitrage desk had been involved in the largest "arbitrage disaster" (when the merger announced by Honeywell-GE was crippled by a ruling from the European Commission), involving an estimated $2.1 billion in losses to the professional arbitrage community. Beunza and I speculated that the magnitude of the losses occurred in part because professional arbitragers lacked diversity. At that time, we were thinking about diversity of models. In any case it was speculation. This work with Sheen indicates that ethnic diversity can be important and we hope it invites further research on gender diversity as well. 

How diverse does a market have to be in order to see these results? 

SL: We put some statistical analysis into this question. In our setting — a financial market, anonymous traders — simply having more than one ethnicity improves performance dramatically. It's plausible that in a team setting, when people could see who’s saying what, having more ethnicities would lead to better performance.

How do you imagine your findings being implemented in real life? Is there a model that can be replicated or incorporated by various companies? How do you envision such a step? 

SL: Studying markets is a cautious strategy, because in a market people compete and take advantage of other people's mistakes. If, as we find, markets populated by skilled traders who possess complete information are still so affected by homogeneity, it may have an even more pronounced role in other instances of herding, such as the spread of fashions, fads, false beliefs, and riots.

Teams, groups and crowds are much more susceptible to herding — just think of examples of groupthink in the political realm or street riots. Our results suggest that ethnic diversity facilitates friction. This friction can disrupt conformity and prevent herding. The presence of more than one ethnicity fosters greater scrutiny and more deliberate thinking, which can lead to better outcomes. Of course, it can also cause conflict and complicate decisions. Managing diversity is key.

DS: Our findings suggest that ethnic homogeneity promotes conformity and hence mispricing. It indicates that ethnic diversity disrupts conformity and leads to improved information processing. If I were the chairperson of a corporate board and read this study, together with research by Kathy Phillips here at the Columbia Business School, I would want to make sure that my corporate board was ethnically diverse.  Diversity is a value in itself. It needs no further justification. But there are people in the business community who also understand that actions that promote diversity are not only the right thing to do but can also contribute to the bottom line. 

Q&A Compiled by Sabrina Buckwalter