What Is the Winner's Curse?
You might have heard of the winner's curse—it's that tendency where the winning bid in an auction goes beyond the item's actual intrinsic value or true worth. I see this gap between the auction price and real value coming from things like incomplete information, emotions, or various subjective factors that affect bidders.
Generally, these subjective elements create the value gap because it's tough for you as a bidder to pin down and justify the item's true intrinsic value. That's why the biggest overestimation often wins the auction.
Key Takeaways
- 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 came from three engineers at Atlantic Richfield who noticed poor returns from companies bidding on offshore oil drilling rights in the Gulf of Mexico. In investing, you'll often see it in initial public offerings (IPOs), but really, this theory applies to any auction-based purchase.
As you probably know, intrinsic value is something you can usually quantify, but real-life situations and subjective factors make those estimates unclear in the moment. If everyone had perfect information and made completely rational decisions with expert valuation skills, we'd have a fully efficient market with no overpayments or arbitrage chances.
But efficient markets are great in theory—history shows they're never 100% achievable. Emotions, irrationalities, rumors, and other subjective factors push prices way beyond true values.
At its core, the winner's curse combines cognitive and emotional friction, and you usually spot it after the fact. You win the asset, but it's likely worth much less in resale due to factors that affected the purchase and will influence its future value.
Important Note
The winner's curse can lead to buyer's remorse, where you feel like you've overpaid once you look back on it. Overall, if you have to bid more than others to get something, there's a good chance you're paying more than you wanted. Unfortunately, you often only realize this after the deal is done.
An Example of the Winner's Curse
Consider Jim's Oil, Joe's Exploration, and Frank's Drilling all going after drilling rights for a specific area. Suppose, after figuring in all drilling costs and potential revenues, those rights have an intrinsic value of $4 million. Now imagine Jim's Oil bids $2 million, Joe's Exploration bids $5 million, and Frank's Drilling bids $7 million.
Frank's wins the auction but overpays by $3 million. Even if Joe's Exploration knows that price is too high, they can't do anything—the highest bid wins, no matter how overpriced it is.
