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Friday, 18 July 2014

W is for Winner's Curse

The Winner's Curse occurs when in order to win a competitive pricing situation such as an auction we overpay. By overpaying we destroy the investment case for buying in the first place and the losers turn out to be the winners. Of course, overpaying for anything is unfortunate, but competition has strange effects on our brains.

Example

Famously mobile network operators were induced to overpay for their UK 3G mobile spectrum licenses in a clever auction designed by economists, who were able to manipulate the process to the advantage of the UK taxpayer and the disadvantage of the telco shareholders. Of course, transferring investment dollars from private enterprise to the public purse was a sure-fire way of reducing business investment, but the arguments around this are never likely to be resolved.

House price booms can cause similar issues when people overpay at the top of the market in competitive situations, as can stockmarket booms - the dotcom bubble was an example of this when people were desperate to buy overpriced stocks because of the dotcom label.  IPOs are the most common way private investors run into the problem because informed inside investors won't buy if the pricing is fair or expensive so stock is often only available when people are prepared to overpay for it.

Causes

In the main the winner's curse is an emotional response to what should be a straightforward issue of intrinsic valuation. Unfortunately valuations are often hard to figure out and in competitive situations people can let their emotions run away with them.

Mitigation

Generally in IPOs the people selling know a lot more about the value than the people buying - so unless there's some blatant reason why the stock is obviously underpriced private investors should steer clear of flotations. More generally investing should be done as unemotionally as possible, it's not a competitive sport, it's a game of skill in which success is measured over years, if not decades.

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