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The Winner’s Curse

Ebay is the epitome of “buyer’s remorse”.  If you have ever been bidding on an Ebay item and watched the last few minutes of the auction you will often find that there is a frenzy of activity right before the last seconds tick away.  If you are able to sit back and rationally think about how much that object is worth to you, then you forgo bidding again once the bidding price reaches the price that it is worth to you.  Obviously the idea in paying for something is to only pay at or less than what the item is worth to you.  This amount can be different between two parties.  In the Ebay world, the item might have sentimental value to one person whereas it only has functional value to another person.  The problem is that these values get thrown out the door in the heated world of Ebay bidding.  Oftentimes the ending buyer pays much more than any rational person would pay for that object simply because they didn’t want to lose.  This is the Winner’s Curse.

The Winner’s Curse states two outcomes:

  1. The winning bid exceeds the value of the auctioned item so that the buyer is worse off in absolute terms
  2. The value of the auctioned item is less than the bidder estimated so that the bidder is worse off than anticipated

The sealed contractor’s bid is often cited as a concrete example of the winner’s curse.  A city or local government puts out a project for bid, say the building of a bridge, and the contractors submit their bids for what they are willing to complete the task for.  The winner of this sealed bid is generally dissatisfied because he most likely under-estimated what it would cost to build the bridge and therefore won the contract (unless the bidding was rigged and the politicians were greased).

The behavioral response that comes out in auctions or a bidding process is emotional in nature.  If you have ever watched the first time home buyers fret on an HGTV episode, you have probably witnessed the “Honey, I really don’t want to lose this house.  This is the one.”  In actuality, there are many houses that would be equally fulfilling to those first-time home buyers, but for one reason or another they have become fixated on owning that house.  Eventually that couple will probably come to terms with the fact that they overpaid for that first home, or they will naively convince themselves that they paid a just price.

In the world of finance, the winner’s curse is even more deceptive.  When we invest in stocks we are all playing a game in which we must bid on values of companies by projecting future earnings and cashflows of these companies into perpetuity under future environmental conditions that are utterly unknown.  Sounds daunting.  To make it even more difficult, there are the psychological repercussions of  missing out.  Everyone who invests in stocks has had the, “I wish I would have…” moment.  That thought consistently lingers in the subconscious and emerges as the, “I am not going to miss out on this one!”  That mentality is pervasive during bull markets and it is even more pervasive after a historically quick 60% move upward in equity markets.  The problem is that the emotional force takes much higher precedence than any rational valuation of the underlying fundamentals of the company and/or stock markets.

The next time you find yourself fearful of “missing out”, take a deep breath and walk away from the situation.  There are very few one time opportunities in life, so make sure this time really is a good opportunity, not just a fear of losing.

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