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 gap in auctioned versus intrinsic value can typically be attributed to incomplete information, emotions, or a variety of other subjective factors that may influence bidders.
In general, subjective factors usually create a value gap because the bidder faces a difficult 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.
- 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 gap in auctioned vs. intrinsic value can typically be attributed to incomplete information, types of bidders, emotions, or a variety of other subjective factors.
- Originally, the term winner's curse 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 (IPOs) but comprehensively a winner’s curse can happen in any market where auctions take place.
- The gap between intrinsic and auction value will generally be influenced by the bidders involved.
Understanding the Winner's Curse
The term winner's curse was coined by three Atlantic Richfield engineers, who observed the poor investment returns 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 (IPOs). Comprehensively, the winner's curse theory can be applied to any purchase done through auction.
As most investors know, intrinsic value is usually quantifiable but situations and subjective factors make value estimates more unclear in real-time and real life. Theoretically, if perfect information was available to everyone and all participants were completely rational in their decisions and skilled at valuation, a fully efficient market would exist and no overpayments or arbitrage opportunities would ever occur.
However, while efficient markets are helpful to understand in theory, historically they have proved to be unachievable 100% of the time. Thus, emotions, irrationalities, rumors, and other subjective factors can push prices far beyond their true values.
The winner's curse, at its core, is a combination of cognitive and emotional friction and is usually recognized after the fact. The buyer is victorious in owning whatever asset they are bidding on. However, the asset is likely worth far less in resale value after ownership due to different factors affecting the purchase and influencing its value in the future.
The winner's curse can lead to an example of buyer's remorse, wherein the buyer of something feels like they've overpaid in retrospect.
Overall, when an individual has to bid more than somebody else to get something, there is a good chance they end up paying more than they had wished. Unfortunately, it's often only after the transaction has taken place that they see this.
An Example of the Winner's Curse
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 potential future revenues, the drilling rights have an intrinsic value of $4 million. Now let's imagine 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.