What is the Winner’s Curse?
The winner’s curse is a tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item. The difference between the auctioned price and intrinsic value often arises due to incomplete information, emotions, or various subjective factors that may influence bidders.
In general, subjective factors usually create a value gap because the bidder faces a challenging time determining and rationalizing an item’s true intrinsic value. As a result, the largest overestimation of an item’s value ends up winning the auction.
Key Takeaways
- The winner’s curse is the tendency for the winning bid in an auction to exceed the intrinsic value or true worth of an item.
- The discrepancy between auctioned vs. intrinsic value can usually be attributed to incomplete information, the types of bidders, emotions, or various subjective factors.
- Originally, the term winner’s curse emerged from companies bidding for offshore oil drilling rights in the Gulf of Mexico.
- In the investing world, the term often applies to initial public offerings (IPOs), but broadly, a winner’s curse can occur in any market where auctions take place.
- The difference between intrinsic and auction value is influenced by the participants involved.
Unveiling the Winner’s Curse
The term winner’s curse was coined by engineers at Atlantic Richfield who observed the poor returns realized by companies bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing realm, the term often applies notably to initial public offerings (IPOs). Theoretically, the winner’s curse concept can apply to any auction-based purchase.
Most investors are aware that intrinsic value is typically quantifiable, but various situations and subjective factors can make real-time and real-life value estimates less clear. Ideally, if perfect information was accessible to everyone, and all participants made completely rational decisions while being skilled at valuations, an entirely efficient market would exist without overpayments or arbitrage opportunities.
Nevertheless, complete market efficiency remains largely theoretical. Historically, efficient markets haven’t consistently been achievable. Emotions, irrational behavior, rumors, and other subjective factors often push prices far beyond their true values.
At its core, the winner’s curse comprises cognitive and emotional friction and is commonly recognized after the occurrence. While the victorious buyer secures the intended asset through their formidable bid, they find the asset considerably below their paid value in resale due to factors affecting its future worth. This often results in buyer’s remorse, where the buyer, reflecting after the transaction, realizes they overpaid.
Overall, when someone needs to bid more than competitors to acquire something, they’re likely to pay more than they intended. Unfortunately, this realization frequently follows the transaction.
An Illustration of the Winner’s Curse
Jim’s Oil, Joe’s Exploration, and Frank’s Drilling are all pursuing drilling rights for a particular area. Suppose, considering all drilling-related expenses and potential future revenues, the drilling rights possess an intrinsic value of $4 million. Imagine that Jim’s Oil bids $2 million, Joe’s Exploration $5 million, and Frank’s Drilling $7 million.
Although Frank’s won the auction, it ended up overpaying by $3 million. Even if Joe’s Exploration knows for sure that this price is excessively high, it cannot change the outcome, as the highest bid always wins the auction, irrespective of how overpriced the bid may be.
Related Terms: Intrinsic value, Initial public offerings (IPOs), Efficient market, Arbitrage, Buyer’s remorse.
References
- E.C. Capen, R.V. Clapp, W.M. Campbell. “Competitive Bidding in High-Risk Situations”. Journal of Petroleum Technology, 1971.
