Ethnicity, Trust and Financial Bubbles

Ethnicity, Trust and Financial Bubbles

Financial “bubbles” occur as a result of the regular revaluation of assets and they are one of the main types of market failure. People may be in error when making decision on the value of one or another asset traded on markets, deviating from the asset “true” value upward or downward. But there is a belief that errors like these are truly individual, independent from each other and are not systematic. A trader who valuated a tech company’s stock higher than its “true” value will pay for its error by attracting more rational competitors, which will make money on selling the overvalued asset. Correction will come soon or late: supply will exceed demand and prices will return to the previous level which more precisely reflects the “true” value of assets. Traders’ errors are occasional, and the demand and supply mechanism automatically provides protection of the market against “bubbles".

 

Why do “bubbles” occur, though? Human rationality constraints, the incompleteness of information, emulation effects and certain financial environment (for example, excess liquidity) contribute to this. But financial trading is a collaborative process, therefore, social factors cannot be discounted. American sociologists were able to experimentally demonstrate that errors in trading and the formation of “bubbles” are affected by such thing as the ethnicity of traders.

 

Diversity for Benefit?

 

 

Suffice it to say, ethnic diversity reduces the probability of occurring bubbles. It has been traditionally regarded that cognitive diversity improves the quality of decisions taken in organizations and teams: if there are people with different backgrounds, skills and knowledge, and different approaches to resolve issues, as well as with different world views, this reduces the risk of errors in groupthink and ensures anytime access to the new information, nourishing creativity. With regard to ethnic diversity, it is more complicated: for example, ethnically heterogeneous labour collectives deliver innovative results oftener, but they are more conflict-prone. And vice versa, ethnic homogeneity may lead to enhanced trust, including in decisions which are taken by others, their colleagues or competitors.

 

Such observations, in themselves, do not mean value judgments. For example, trust feeds collusive corruption or terrorist rings in a similar way as it may be a required element of collective action or a valuable resource for doing business. The question is, in which institutional context trust-based relations are developed. For ethnic business persons, carrying out their activity in a foreign country, trust is a key to success. On the contrary, in the present-day financial markets, where scepticism is the master virtue, relying on an opinion of another means taking the risk of repeating his or her error. In this context, the enhanced trust built as a result of the ethnic homogeneity of participants becomes a problem.

 

The Essence of Experiment

 

 

The study was conducted in various regions of the United States and Southeast Asia that were different as much as possible in terms of economy, culture and ethnic characteristics of their inhabitants: in the first case, these were the White, the Afro-Americans, and the Hispanics; in the second case, there were the Chinese, the Malays and the Hindus. Moreover, in both cases, people differently perceived ethnic differences. The scientists formulated a “pool” of prospective testees among people who studied business or finance or had practical experience in trading, and then they randomly selected two groups of 6 persons each. The selection was made in such a way that only representatives of ethnicity which was the most numerous in such populated locality were included in a control group, and an experimental group included at least one person belonging to another ethnic group. Totally, 30 experiments were conducted with the participation of 180 people.

 

The testees participated in a computer-based simulation of financial trading, similar to electronic trading platforms, popular today, and received a monetary reward for that. It was intended that they would trade a predetermined lot of stock, being armed with comprehensive and precise information and possessing tools necessary for pricing, including the examples of correct estimations. In addition, the participants could see each other and take note of ethnic belonging of other members of the group.

 

At the first stage, the scientists measured the “basic” level of accuracy with which the testees determined the value of assets. After reading the instructions, the participants in the experiment were offered typical market scenarios according to which they individually determined the value of a stock, not knowing each other’s valuation results. In doing so, the experimenters got an average measurement of each group’s accuracy in a “pure” case when the effects of social factors were minimum.

 

At the second stage, the testees received the necessary amount of money for trading, and trading started. Like in real-world markets, the participants in the experiment traded using a computer-based terminal, on which they could track movements in prices and changes in the volume of trade, transactions and buy or sell requests (bid and ask). The testees knew about the ethnic composition of their group, but they did not see each other, could not communicate directly, and also could not find out who exactly among other traders made this or that transaction or made a request. At the close of trading, the participants received money so earned, and the experimenters measured again how accurate the testees had valued the stock, i.e. how much each of groups had deviated from the correct value, on the average.

 

Trust, But Watch Out

 

 

The design of the experiment made it possible to isolate the impact of ethnic composition of the trader groups on trade performance: the participants had an idea about ethnic belonging of each other without being able to communicate or to watch each other directly. The inability of direct communication and the lack of visual contact does not exclude the possibility of emulation: often, in their valuation, traders go along with the majority view, which they reconstruct from their observations over the activity in the market, in other words, over decisions taken by other traders. The experiment studied the influence of the ethnic composition on such effects, i.e. on trust in decisions made by other people.

 

In aggregate, 180 traders grouped in 16 ethnically homogenous and 14 ethnically heterogeneous groups participated in the experiments in both regions. During the trading process they made more than 2 thousand transactions, analysis of which shows that ethnic composition significantly affects the valuation accuracy of traded assets. It improved by 21% in heterogeneous groups as against its “basic” value, while an opposite effect was observed in homogenous groups: the accuracy decreased by 33% from the reference level. During the trading process, the valuation becomes more accurate as the traders gain more experience. In ethnically homogenous groups, however, it is not only that the accuracy is not improved, it is significantly hampered: even experienced traders begin to make errors, and the market does not correct them but compounds them: assets are regularly revalued, resulting in “bubbles”. Traders in homogenous groups are more inclined to trust decisions made by their colleagues on the other side of the screen as they belong to the same ethnic group, i.e. they “trust their own people".

 

 

 

Valuation of financial assets is a complicated cognitive process, during which errors inevitably occur. The authors of the experiment suggest that the issue is not just the individual abilities or limitations: since trading is a collaborative activity, decisions of individuals are affected by social factors, in particular, by the ethnicity of other traders. People are inclined to trust those, whom they take as “their own people”, and ethnicity serves as a reliable marker according to which “own people” are distinguished from “strangers”. As the mechanism of influencing is indirect, it would be more correct to say that the quality of trading is affected not by ethnic composition in itself, but by traders’ perception of the ethnicity of other traders. In other words, this story is not about racism and xenophobia, but about contingency rundown mechanisms for decision-making process.

 

The experiment suggests that the effect observed therein is of the generalized nature and does not depend on traders' belonging to specific ethnic groups, their cultural or regional background. In the real-world markets, unlike with controlled experimental conditions, errors will be more strongly pronounced, and their consequences - much more serious.