Curb Your Enthusiasm: Winner’s Curse
Texas in the 1950s. A piece of land is being auctioned. Ten oil companies are vying for it. Each has made an estimate of how much the site is worth. The lowest assessment is $10 million, and the highest is $100 million. The higher the price climbs during the auction, the more firms exit the bidding. Finally, one company submits the highest bid and wins. Champagne corks pop.
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 oil field auctions systematically paid too much and years later went under. This is understandable. If the estimates vary between $10 million and $100 million, the actual value most likely lies somewhere in the middle. The highest bid at an auction is often much too high—unless these bidders have critical information others are not privy to. This was not the case in Texas. The oil managers actually celebrated a Pyrrhic victory.
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. Airports rent out their commercial spaces to the highest bidder. And if Walmart plans to introduce a new detergent and asks for tenders from five suppliers, that’s nothing more than an auction—with the risk of the winner’s curse.
The auctioning of everyday life has now reached tradesmen, too, thanks to the Internet. When my (Rolf Dobelli) walls needed a new lick of paint, instead of tracking down the handiest painter, I advertised the job online. Thirty painters from more than three hundred miles away competed for the job. The best offer was so low that, out of compassion, I could not accept it—to spare the poor painter the winner’s curse.
Initial public offerings (IPOs) 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. A friend owns a micro-antenna factory and told me about the cutthroat bidding war that Apple instigated during the development of the iPhone. Everyone wants to be the official supplier to Apple, even though whoever gets the contract is likely to lose money.
So how much would you pay for $100? Imagine that you and an opponent are invited to take part in such an auction. The rules: Whoever makes the highest offer gets the $100 bill, and—most important—when this happens, both bidders have to pay their final offer. How high will you go? From your perspective, it makes sense to pay $20, $30, or $40. Your opponent does the same. Even $99 seems like a reasonable offer for a $100 bill. Now, your competitor offers $100. If this remains the highest bid, he will come away breaking even (paying $100 for $100), whereas you will simply have to cough up $99. So you continue to bid. At $110, you have a guaranteed loss of $10, but your opponent would have to shell out $109 (his last bid). So he will continue playing. When do you stop? When will your competitor give up? Try it out with friends.
In conclusion: Accept this piece of wisdom about auctions from Warren Buffett: “Don’t go.” If you happen to work in an industry where they are inevitable, set a maximum price and deduct 20 percent from this to offset the winner’s curse. Write this number on a piece of paper and don’t go a cent over it.
* Source: The Art of Thinking Clearly by Rolf Dobelli