A winner’s curse is a situation where the winning bid of any asset in an auction exceeds its common value or true worth. The term winner’s curse was originally coined in the Gulf of Mexico as a result of being the winning bidder for offshore oil drilling rights.
In the world of finance and investment, the term is generally applied to IPOs (initial public offerings) but it can take place in any market where auctioning occurs for winning bid.
What is Winner’s Curse?
Definition – Winner’s curse is defined as a phenomenon that takes place in common value auctions in which all bidders have the same (ex-post) value for an asset but they receive varied private (ex-ante) signals about the asset’s value and then the winner will be the bidder who bids with the most optimistic evaluation of the asset.
This process would ultimately curse the winner’s bid by letting him or her overestimate and overpay. All in all, the winner’s curse is a gap between the auctioned value and the actual value of a given item. The occurrence of this particular gap is generally the result of incomplete information, emotions, types of bidders, and other similar factors that influence the estimation to surpass the intrinsic value of the asset.
However, it is said that the type of bidder involved heavily influences the gap. It is said that the winner of the auction is cursed in either of the two ways-
- The winning value exceeds the true worth of the item won by the bidder, making the winner worse off in absolute terms.
- The value of the item being auctioned will be less than what the bidder anticipated. In this sense, the bidder will gain the thing but will be worse off than expected.
The phenomenon of the winner’s curse was first coined in the year 1971 by the three Atlantic Richfield petroleum engineers. The name of those individuals who addressed this issue was Capen, Clapp, and Campbell.
In their published work, “Competitive Bidding in High-Risk Situation,” three of them claimed that the oil companies suffered from low returns every subsequent year due to poor investment.
Understanding The Winner’s Curse
In the market, investors are well aware that the intrinsic value of an asset changes depending on the various subjective factors. The value estimates are always unclear in real-time and real life. In a practical situation, perfect information does not exist.
This is why the participants have to consider various factors to determine the rationality in their decision. And also rely on their skilled ability of valuation. The factors like emotions, irrationalities, rumors, and so on can push the prices of the auctioned asset or item far beyond their actual intrinsic value.
The core of the winner’s curse incorporates an amalgamation of cognitive and emotional friction. And this is usually recognized after the fact. At the time when the bidder is celebrating the victory of their winning in bidding, at that moment, the bidder fails to recognize the actual value of an asset. In other words, the asset won was probably auctioned off at a high value, but in reality, its true value wasn’t that valuable.
Overall, the individual has to bid more than the other individuals to attain that asset in the bidding scenario. Hence it opens up a path where the winner has to pay more than want was desired. Unfortunately, it is only after the transaction is made that the winner recognizes the true value.
How to Avoid Winning Curse in an Auction
Auctions are very common in today’s world. Therefore, to avoid being a victim of the winner’s curse, it is essential to follow a few guidelines given below-
- Analyze the asset that is being bided. Check whether it has an expected value element. If it has, then bid with caution.
- Do not go beyond your means or capability to win an asset in the auction. Always keep a close eye on the other bidders on how much they are ready to offer.
- Before placing each bid, take time to access the items being auctioned. And consider the emotion how one would feel on having won that item.
It is a usual scenario that most winners end up feeling cursed due to their victories. In competitive bidding, the negotiation is bound to raise the asset’s value than its actual worth.
You should evaluate the bidding just as one would while bargaining. One can always back off when the cost is exceeding the true value of the auctioned asset. Therefore sometimes, the best alternative to winning an auction is not to win an auction.
Tips for a Winning Bidder to avoid the Winner’s Curse
1. Determine the value of an asset being auctioned
Before one starts bidding, it is crucial to evaluate whether the asset is private-valued or common-valued. If it is the former, then it offers unique value to different bidders. However, when it comes to common-valued investments, one has to be wary of the bidding. For example, a jar of the coin has an equal value to all the bidders despite being unclear how profitable it will be.
2. Figure out if it’s worth paying
In competitive bidding, it so often happens that the winner ends up paying more for an asset than its original worth. In the case of a private-valued asset, each bidder holds a different value. Therefore the winner doesn’t regret buying it even if it has to pay more than its actual amount. But since the common valued asset has the same value as all the bidders. Therefore wining that auction by bidding a high amount will seem worthless after the transaction.
Before making a bid, one must first reason out how it will feel after winning the auction. Is it worth paying that much amount? In the private valued asset case, one doesn’t regret paying high value to procure the asset. But if it is a commonly valued asset, then one would end up regretting winning the bid.
Winner’s Curse and The Linkage Principle
The linkage principle of the modern auction theory was developed by Paul Milgrom, an American economist. According to the linkage principle, in an auction, when the bidders bid, the expected price of an asset rises the more the price is linked to its actual value. But in the parallel fashion, the expected price of an asset in the auction where bidders are selling falls.
Therefore linking price to the value of an asset improves the performance of the auctions. For example, the government has proposed to purchase by auction a contract stating the delivery of 10,000 gallons of gasoline each week for the period of next year.
Due to this now, the supplier will face the risk in the form of gasoline prices. In case the government makes a purchase at a fixed price, then the supplier’s bid will build a way to compensate for the risk and for the winner’s curse.
In addition, because the price of gasoline will vary in the future dates, the suppliers will be able to gain profit based on their private information about the value.
However, if the government decides only to buy delivery and separately pays for the gasoline, the profits that the bidders have estimated will be nullified. Therefore it will result in the overall fall of the profit levels.
Paying the cost of gasoline reduces the incentive of the suppliers. Therefore the agency incentive effect should be balanced against the reduction in the bidder’s profits from the auction at the time of selecting a supplier.
Examples of Winner’s Curse
A professor decided to auction off a Jar full of coins to the students. With more than three students bidding, the jar’s value kept on increasing with each bidding. Finally, the auction was settled, with the winner bidding it for $60. After the transaction, the winner will realize that winning was not worth it because the jar had coins worth $30.
Game bidding is a classic instance of the winner’s curse phenomenon in competitive bidding. Lack of understanding of this phenomenon will lead the winner to buy an item from an auction at a value that is not worth it. Therefore paying more than the actual worth of the thing.
In most of the context, the bidders are not aware of the actual value of an item that is being auctioned. Also, the necessary information that is relevant to the valuation of an item. Naïve bidders tend to lose more money despite winning.
Some of the auctions where the winner’s curse is significant
- Spectrum auction where the companies bid on the licenses to use the portion of the electromagnetic spectrum.
- IPOs in which the bidders bid for the company’s stock.
- Free agency in professional sports
- Federal offshore oil lease
We hope the aforementioned tips would help bidders avoid the winner’s curse.
Do you have some other instances of winner’s curse occurrence? Share with us in the comment section below.