The Art of Thinking Clearly: Better Thinking, Better Decisions

See also Simple Logic (ch. 63); Neglect of Probability (ch. 26); The Law of Small
Numbers (ch. 61)

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35
CURB YOUR ENTHUSIASM
Winner’s Curse
Texas in the 1950s. A piece of land is being auctioned. Ten oil companies are
vying for it. Each has made an estimate of how much the site is worth. The lowest
assessment is $10 million, and the highest is $100 million. The higher the price
climbs during the auction, the more firms exit the bidding. Finally, one company
submits the highest bid and wins. Champagne corks pop.
The 
winner’s curse
suggests that the winner of an auction often turns out to be
the loser. Industry analysts have noted that companies that regularly emerged as
winning bidders from these oilfield auctions systematically paid too much, and
years later went under. This is understandable. If the estimates vary between $10
million and $100 million, the actual value most likely lies somewhere in the
middle. The highest bid at an auction is often much too high – unless these
bidders have critical information others are not privy to. This was not the case in
Texas. The oil managers actually celebrated a Pyrrhic victory.
Today, this phenomenon affects us all. From eBay to Groupon to Google
AdWords, prices are consistently set by auction. Bidding wars for cellphone
frequencies drive telecom companies to the brink of bankruptcy. Airports rent out
their commercial spaces to the highest bidder. And if Walmart plans to introduce a
new detergent and asks for tenders from five suppliers, that’s nothing more than
an auction – with the risk of the 
winner’s curse
.
The auctioning of everyday life has now reached tradesmen, too, thanks to the
Internet. When my walls needed a new lick of paint, instead of tracking down the
handiest painter, I advertised the job online. Thirty painters, some from more than
300 miles away, competed for the job. The best offer was so low that, out of
compassion, I could not accept it – to spare the poor painter the 
winner’s curse
.
Initial Public Offerings (IPOs) are also examples of auctions. And, when
companies buy other companies – the infamous mergers and acquisitions – the
winner’s curse
is present more often than not. Astoundingly, more than half of all
acquisitions destroy value, according to a McKinsey study.

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So why do we fall victim to the 
winner’s curse
? First, the real value of many
things is uncertain. Additionally, the more interested parties, the greater the
likelihood of an overly enthusiastic bid. Second, we want to outdo competitors. A
friend owns a micro-antenna factory and told me about the cut-throat bidding war
that Apple instigated during the development of the iPhone. Everyone wants to be
the official supplier to Apple even though whoever gets the contract is likely to
lose money.
So how much would you pay for $100? Imagine that you and an opponent are
invited to take part in such an auction. The rules: whoever makes the highest offer
gets the $100 bill, and – most importantly – when this happens, both bidders have
to pay their final offer. How high will you go? From your perspective, it makes
sense to pay $20, $30 or $40. Your opponent does the same. Even $99 seems
like a reasonable offer for a $100 bill. Now, your competitor offers $100. If this
remains the highest bid, he will come away breaking even (paying $100 for
$100), whereas you will simply have to cough up $99. So you continue to bid. At
$110, you have a guaranteed loss of $10, but your opponent would have to shell
out $109 (his last bid). So he will continue playing. When do you stop? When will
your competitor give up? Try it out with friends.
In conclusion: accept this piece of wisdom about auctions from Warren Buffett:
‘Don’t go.’ If you happen to work in an industry where they are inevitable, set a
maximum price and deduct 20% from this to offset the 
winner’s curse
. Write this
number on a piece of paper and don’t go a cent over it.