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 of the item purchased. Because of incomplete information, emotions or any other number of factors regarding the item being auctioned, bidders can have a difficult time determining the item's intrinsic value. As a result, the largest overestimation of an item's value ends up winning the auction.
Originally, the term was coined as a result of companies bidding for offshore oil drilling rights in the Gulf of Mexico. In the investing world, the term often applies to initial public offerings.
BREAKING DOWN 'Winner's Curse'
For example, say Jim's Oil, Joe's Exploration and Frank's Drilling are all courting drilling rights for a specific area. Let's suppose that, after accounting for all drilling-related costs and future potential revenues, the drilling rights have an intrinsic value of $4 million. Now let's suppose that Jim's Oil bids $2 million for the rights, Joe's Exploration $5 million and Frank's Drilling $7 million. While Frank's won the auction, it ended up overpaying by $3 million. Even if Joe's Exploration 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.
As intrinsic value is subjective, situations aren't so clear-cut in real life. Theoretically, if perfect information was available to everyone and all participants were completely rational in their decisions and skilled at valuation, no overpayments would occur. However, in the same way that bubbles in the stock or real estate markets are created, people tend to be irrational and push prices beyond the true values of the assets involved.