Consider this thought experiment –
A friend of yours is the Chairman of the Acme Oil Company. He occasionally calls with a problem and asks your advice. This time the problem is about bidding in an auction. It seems another oil company has gone into bankruptcy and is forced to sell off some of the land it has acquired for future oil exploration. There is one plot Acme is interested. Until recently, it was expected that only three firms would bid for the plot, and Acme intended to bid $10 million. Now they have learned that seven more firms are bidding, bringing the total to ten. The question is, should Acme increase or decrease its bid? What advice would you give?
Do you advise bidding more or less?
If you’re like me and seeing this case study for the first time you’d probably go with a higher bid. After all, there are additional bidders, and if you don’t bid more you won’t get this land. Isn’t it?
Unfortunately, if you decide to increase the bid, you’d be falling in a trap called Winner’s Curse. The above example of oil auction comes from Richard Thaler’s book The Winner’s Curse. Thaler writes –
Most people’s intuition in this problem is to bid more…However, there is another important consideration that is often ignored. Suppose that each participant in the auction is willing to bid just a little bit less than the amount he or she thinks the land is worth (leaving some room for the profits). Of course, no one knows exactly how much oil is in the ground: some bidders will guess too high, other too low. Suppose, for the sake of argument, that the bidders have accurate estimate on average. Then, who will be the person who wins the auction? The winner will be the person who was the most optimistic about the amount of oil in the ground, and the person may well have bid more than the land is worth. This is the dreaded winner’s curse.
In other words, the winner’s curse says that in a competitive auction, the highest bidder will typically overpay for the asset. Hence the bidder “wins” the auction but is “cursed” by the overpayment.
“Winning is an informative event, telling us whose estimate was most optimistic,” writes Peter Bevelin, in his book Seeking Wisdom “When we place a bid on a house, company, project, or negotiate to buy something, we don’t realize what is implied by an acceptance of our offer. That we may have overestimated its value and therefore paid too much.”
Following are the key characteristics of a winner’s curse situation –
- There are many bidders. That’s because auctions, by definition, are competitive. If there is only one bidder it is not an auction, it is a sale.
- No one is certain about the true value of the asset being auctioned.
- The winner is typically the one who is most optimistic about the value of the asset.
Winner’s curse becomes very important mental model in corporate mergers and acquisitions, because when companies bid against one another to buy a target corporation, the highest bidder frequently pays too much.
In his book, The Art of Thinking Clearly, Rolf Dobelli writes –
The Winner’s curse suggests that the winner of an auction often turns out to be the loser. Industry analysts have noted that companies that regularly emerged as winning bidders from these oilfields auctions systematically paid too much, and years later went under. This is understandable…The highest bid at an auction is often much too high – unless these bidders have critical information other aren’t privy to.
Today this phenomenon affects us all. From eBay to Groupon to Google AdWords, prices are consistently set by auction. Bidding wars for cell phone frequencies drive telecom companies to the brink of bankruptcy.
Initial public offerings (IPO) are also examples of auctions. And, when companies buy other companies – the infamous mergers and acquisitions – the winner’s curse is present more often than not. Astoundingly, more than half of all acquisitions destroy value, according to a McKinsey study.
So why do we fall victim to the winner’s curse?
First, the real value of many things is uncertain. Additionally, the more interested parties, the greater the likelihood of an overly enthusiastic bid.
Second, we want to outdo competitors. The buyer in an auction is no longer just purchasing a product, he or she is engaged in a test of will, trying to outdo other participants. Remember Warren Buffett’s words – It’s not greed that drives the world, but envy.
According to Charlie Munger, open-outcry auctions are a perfect setup for driving people to highly irrational behaviour. Auction is a place where multiple psychological biases act together, creating a lollapalooza effect, and results in a series of bad decisions.
The list of cognitive biases that are at play in an auction is just mind boggling. Here’s a sample that I pulled out from Prof. Bakshi’s recent blog post–
… an open-outcry auction situation is a very interesting social setting where multiple models from psychology like authority (where the auctioneer is a symbol of authority who not only certifies the authenticity of the object being auctioned, he also announces an initial big price which serves as an “anchor”, social proof (caused by observing other bidders bid up the price), the incentives of the auctioneer (the higher the price at which the object sold, the more the money made by the auctioneer), reciprocation/retaliation (resulting in competitive bidding), envy , low contrast effect (every new bid is a small increment over a previous bid), commitment bias (every bid and escalation of the bid is a public commitment), overconfidence, and deprival super reaction (caused by the countdown to end of auction) combine to turn this social setting into something like a death trap.
Many business acquisitions are justified using fancy jargons such as ‘synergistic benefits’ and ‘strategic advantage’. But what really happens in most acquisitions? The winning bid is largely a result of overestimation of future benefits and succumbing to the competitive pressures (with investment bankers adding fuel to the fire). One just has to look at the projected ‘synergistic benefits’ at the time of benefits and the actual results a couple of years down the line.
If you want see the proof, you don’t need to go very far. In his post, Prof. Bakshi quotes the example of Tata Steel’s disastrous acquisition of Corus in 2006 in a competitive open-outcry auction.
Just before Tata Steel’s first bid on 20 October, 2006, the market cap of the company was about Rs 26,000 cr. On 31 January, 2007 Tata Steel won its bid for Corus after offering 608 pence per share for the target company, valuing it for about $11 billion. Eight years later, Tata Steel’s market cap stands at Rs 23,000 cr. What an amazing case of value destruction! And Hindalco’s acquisition of Novelis was not different.
Knowing what happens to people who get into open-outcry, auction-like situations, psychologically astute people like Buffett and Munger have a no-fault rule when they get invited to auction situations.
The rule is: Don’t Go.
When you win an auction, what you win is the right to pay more (for the asset being auctioned) than everyone else thought it was worth. Explained in this way, it’s quite easy to see why Warren Buffett had this simple “Don’t Go!” advice for auctions.
Winner’s curse presents itself not just in auctions and large M&A activities but even in smaller business decisions.
Let’s say you are the business head who has limited resources to execute only one project among many. All your 10 reporting managers have presented their plans to you. Which one would you pick? Of course, the one that looks most attractive. Isn’t it? But all managers have an incentive to make their own project the most attractive one. The risk is therefore that you end up choosing the project with the most optimistic forecast. Which means you selected the one which has higher chances of turning out to be more expensive and time consuming than it was initially projected to be.
The winner’s curse does not need a fancy auction. The same curse may be visited on an investor in a hurry to buy a stock on which someone has provided a hot tip. During bull markets, the rising prices and increasing demand for the stocks creates an auction like environment. As the price of equities climb, more and more people get enticed into making higher bids and driving the prices even higher.
In effect, people who agree to buy stocks at inflated prices are being overly optimistic, just like an auction winner, about the future prospects of the businesses which those stocks represent.
If you want to participate in the stock market auctions, you must ascertain the true value of what’s being offered. Peter Bevelin, in his book Seeking Wisdom, writes (emphasis mine)-
Research shows that the more bidders there are competing for a limited object, each having the same information, and the more uncertain its value is, the more likely we are to overpay. Instead, if our objective is to create value, the more bidders there are, the more conservative our bidding should be. This also implies that the less information we have compared to other bidders or the more uncertain we are about the underlying value, the lower we should bid.
It’s the winner’s curse that Warren Buffett warns us against when he says, “Be fearful when others are greedy.”
So how do you save yourself from Winner’s curse?
First, acquire as much information as you can. If you can determine what an item (or a stock) is worth, you will avoid overspending. And second, know your limits. If you do not have enough information, wait and get some more, and if you think long and hard to establish a top price, stick to it.
Additionally, thinking about following questions can help you in making a rational decision.
- How would I reason if I think it through from the viewpoint of the other person?
- Why are they selling? Don’t forget that the seller might have an informational advantage. So why would I make a better decision than someone who has all the information?
- The other person is most likely to accept our offer when it’s least favourable to us, especially when he or she is anonymous (typical in stock market transactions). What are the chances that the other person’s decision is being made under pressure and is irrational?
In fact, a practitioner of value investing tries to find a situation which is reverse of an auction.
“In value investing,” writes Chetan Parikh in his blog, “you are buying a stock where in many cases sellers are bidding to sell you a company at lower levels (how else do you explain the fact that even 70 years after Benjamin Graham’s Security Analysis, one gets to buy companies at less than cash on the balance sheet). Also most of the estimates are working in your favour if like all good value investors, you insist on a good margin of safety.”
To summarize, in an auction with many bidders, the winning bidder is often a loser. A key factor in avoiding the winner’s curse is bidding more conservatively when there are more bidders. While this may seem counterintuitive, it is the rational thing to do.
Remember, when the applause of the auction is over, you want to make sure you are still happy with the deal.
When we come out, after spending 15-20 years, from our traditional education systems we have pretty narrow slices of knowledge. Most occupations encourage a degree of specialization. Which is why many people view diverse thinking as something that’s nice to have, not something that’s essential to success. But I firmly believe that finding a connection between different disciplines plays a crucial role in advancing our investment skills. In fact, cognitive diversity is a pre-requisite for solving complex problems in every sphere of life, investing being one of them.
Take care and keep learning.