What is a Winner’s Curse?
Winner’s curse is said to act when the highest bidder in a multiparty auction or in a similar scenario bids a value for a product which is higher than its actual or intrinsic worth. Various factors create a gap in the value as the winner struggles to determine the real worth of a commodity or asset.
Winner’s curse can be attributed to emotional and cognitive factors in a bidder. This phenomenon often results in reduced returns for an individual. Winner’s curse occurs because of a lack of understanding and prior knowledge about the asset in consideration.
A, B and C are biding for drilling rights for a specific area. Let’s say, after accounting for all drilling-related costs and potential future revenues, the drilling rights have an intrinsic value of Rs. 4 million. Now let’s imagine that A bids Rs. 2 million for the rights, B bids Rs. 5 million, and C bids Rs. 7 million.
While C won the auction, it ended up overpaying by Rs. 3 million. Even if B is 100% sure that this price is too high, it can do nothing about it, as the highest bid always wins the auction, no matter how overpriced the bid may be.
Winner’s Curse Explained
The term was first used in 1971 in a journal about Petroleum Technology which mentioned companies bidding for oil drilling rights. Since then the term has been applied widely in any purchase that happens over an auction. The term is also popularly used during initial public offerings in the investment world.
Usually, one can anticipate the intrinsic value of an asset, but during an auction many subjective factors come into play like the tendency to confuse winning at any cost with creating value for oneself. Theoretically, in a perfect market, each bidder will have complete information about the intrinsic value of the product and the auction would take place without any arbitrage or overpayment.
But such perfect markets cease to exist in the real world. Thus emotions, rumors, and other subjective factors often push the price of an asset far beyond its intrinsic value. Winner’s curse is usually realised after the auction ends and purchase is done. The winner realises that the asset has far less resale value than the value it purchased for.
How to avoid Winner’s Curse?
Auctions are a crucial part of most of businesses. Mergers and acquisitions, procurement auctions and many other contracts get finalised through an auction, which increases the need to understand the ways to avoid becoming a winner’s curse victim.
Following steps can be followed to avoid the winner’s curse:
· Analyse whether a common value element is present in the asset. If it is indeed present, bid with caution. Presence of a common value element means that it is worth equal to every bidder.
· Assess and compare your capability with that of others.
· Each time before bidding, take time and ask yourself would you feel contented if you win the auction
Above steps can be very helpful in being rational while bidding which in turn would mitigate the chances of you getting the winner’s curse.