When animal spirits cause asset prices to pull away from reality, or to come crashing back down, it’s hard to pretend that the market is a rational machine churning out fair valuations. But knowing the dangers of groupthink and successively avoiding them are two different matters. Taking diverse perspectives into account can help and, according to a new research paper, ethnic diversity in particular leads to more accurate asset pricing.
“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. In addition, when bubbles burst, homogenous markets crash more severely,” says the paper “Ethnic diversity deflates price bubbles,” written by Sheen Levine, Evan, Apfelbaum, Mark Bernard, Valerie Bartlet, Edward Zajac, and David Stark.
Market simulations set up in North American and Southeast Asia
To study the effect of racial diversity, the researchers set up experimental markets in Southeast Asia and North America composed of Chinese, Malay, and Indian people in the first market and White, Latino, and African American people in the second. Only people with a background in finance participated and some basic guidelines on asset pricing were provided, but to set a baseline each individual was also assessed before meeting the rest of the group.
Then there were two different types of groups set up: homogenous groups made up of the region’s ethnic majority, and heterogeneous groups with a mix of ethnicities. The participants traded in an open market with real money at stake, and were paid based on how well they did at the end of the session.
One immediate caveat to this study is that the researchers assume that they know the ‘true value’ of the stocks in question, which would be a pretty neat trick, but we can assume they at least used a reasonable valuation method.
Ethnic diversity: Heterogeneous markets 58% more accurate
In both locations, they found that the diverse markets fit the ‘true values’ 58% better in diverse markets than they did in homogeneous markets. The researchers believe this is because people with the same ethnic background are more likely to trust each other’s assessments and this allows speculative offers to be treated as well reasoned bids within the market. It also found that participating in the market didn’t necessarily make a person’s assessments more accurate, lending some credence to value investors who prefer to ignore market trends and come up with independent valuations before checking what Mr. Market has on offer.
While the effect existed in both markets, that doesn’t mean the two markets were exactly equal. If you believe the researchers’ notion of true value is a good one, than the two regions were markedly different in absolute skill (sorry New York).
The full PDF can be found here PNAS-2014-Levine-1407301111