The Winner’s Curse

The winner’s curse

The hypothesis, that investors are rational enough to evaluate the actual value of an asset and will buy or bid depending on this personal assessment, conclude different kinds of anomalies. One can be defined as the Winner’s curse.

The winner’s curse is a phenomenon that occurs at a common value auction or any other situation where there is competition. In such an auction the bidders all want to buy the auctioned item, which has the same value to all the bidders. The bidding starts after each bidder has figured out for themselves how much the value is. They will bid or pay taking their evaluation into account.

It can be said that the winning bid is often from the most optimistic bidder, who estimates the value of the asset higher than his competitors.

In many cases the winner of the auction has overestimated the value. This goes against the assumption that investors are rational and will only pay the true actual value of the asset.

The difficulty in estimating the true value of the auctioned item lies in the lack of available information of the bidders or the amount of bidders attending the auction.

When bidders have more easy access to relevant information, they can align their evaluation accordingly and they chance of overvaluation is smaller. Or when there are a lot of bidders, the probability of overestimation becomes bigger.

Because each bidder will react more sharply and will raise their bid to make sure that the other bidders get discouraged. This will eventually lead to the winning bid being much higher than the intrinsic value of the asset.

However, in an auction where an item is being desired by the bidders regardless of the value of the market, the winner of the auction is not cursed.

In case of an antique, the possibility of an average bid being too low is high because some bidders don’t have the expertise to evaluate the object properly.

This makes the average bid too low due to exterior market conditions.

The first example can be made in an IPO auction. When a private company wants to become public and sell some of their shares on the market, they will have an IPO. For investors it is very important to evaluate the future market value of the firm who will be listed in a stock market.

Investors who are willing to bid on an IPO of a particular firm don’t always have the same resources to gain relevant information about what the market value of the company’s share will be. That can be the reason why some investors are uninformed and are interested in every IPO, even when the issue price is higher than the true value of the shares. Because of the lack of information they overvalue the shares and they get ‘cursed’. While investors who are informed, only buy shares when the issue price is lower than the actual value.

Another example of situations where there is a presence of the winner’s curse is the excessive lending of banks. The lack of an homogeneity risk assessment of the general risk level has led to a high write- off rate on loans.

This is one of the things that caused the recent financial crisis. It can be said that some banks are too optimistic with the assessment of the general risk level.
Because of the lack of heterogeneity of the credit assessment, it’s possible that one bank is too optimistic and underestimated the creditworthiness of individuals. So they lend money to this people, while in reality these clients were not able to pay back these loans. This resulted in a very high write-off rate on loans.