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Diversity rules in nature and maybe in markets, too

Diversity safeguards populations from defective genes, stabilizes nature’s ecosystems and fosters innovation in business.

Now, research suggests that it may protect financial markets from manic excess. Bubbles form when traders trust others’ judgment without scrutiny, and that happens more in ethnically homogeneous markets, according to a new paper in the Proceedings of the National Academy of Sciences by a team of academics led by Sheen S. Levine and David Stark of Columbia University.

“You get better information processing in ethnically diverse settings,” Stark, a sociologist, says.

To test their thesis, Stark and Levine created six-person minimarkets, some ethnically similar, others diverse. They chose two locales: Singapore, where they recruited Chinese, Malays and Indians, and Texas, where they tapped whites, blacks and Latinos.

Each group traded fake stocks for real money for 10 rounds. The true value of the stocks was designed to fall over the course of trading. Prices should have fallen, too – and, in the diverse groups, that’s what happened.

But in the homogeneous ones, prices often stayed nosebleed high as traders willingly accepted bubble prices from their counterparts. Pricing accuracy proved 58 percent higher in diverse markets, the authors found. In Singapore, where almost all subjects had taken an economics or finance class, it reached almost 90 percent.

We humans tend to let our guard down and go with the flow in homogeneous settings, says Stark. We accept inflated offers and become more likely to spread others’ errors.

“If there’s some diversity, you’re on your game,” he says.

Levine and Stark’s findings also suggest that “crashes are significantly less severe” in diverse markets. Which could mean that recent bubbles might have been even worse if finance weren’t truly global.