The winner's curse

Luckily, your 15-year-old daughter is doing GCSE economics and she describes something she has just been studying, which is called ‘the winner’s curse’. It seems a brilliant wheeze; a dead-cert way of bringing in some dosh. 

Hence the jar full of jelly beans as this week’s object. That’s your prop, the only prop on the stall, unless you count yourself and Fudge, the pet spaniel, who will be there, ready to greet – and slobber over – anyone who comes near. Basically, you ask the punters to do what it says on the jar: guess the number of jelly beans. 

Specifically, punters are asked, via little sealed bids, to guess the number at the rate of 1p per bean. The winner will be whoever makes the highest bid – this is, after all, an auction – and the prize will be the ‘value’ of beans in the jar. Initially, you thought that the winner’s bid should be deducted from the value of the prize, but when your daughter explained the ramifications of the winner’s curse you thought that would be too cruel; there is a limit to how much you want to exploit your fellow villagers, even for a good cause. 

In the event, everything goes swimmingly. The English summer is at its best, as is Fudge’s behaviour. And the pundits flock in. As part of a school-work project, your daughter records all the details and finds that there were 48 bids and the average bidder reckoned the jar contained 513 beans; whereas the actual number was 800. Meanwhile, the winning bid was for 1,001 beans. In money, that meant your stall’s gross proceeds were £246.24, which netted down to £238.24 after paying out £8 to the winner. 

Now you grasp why it’s called ‘the winner’s curse’. Even the winner lost, though, luckily, it was the nice old lady who lives in one of the almshouses and she took it in good spirit; if it had been that hedge-fund manager, who has just bought the old rectory, there might have been trouble. 

From this, two truths arise from the winner’s curse. First, in an auction of sealed bids, the average bid will be significantly less than the value of what is bid for. Second, the winning bid will exceed the object’s value. If you doubt these, consider that the data about the auction at the fictional summer fete were extracted from actual numbers derived from a series of controlled experiments where students at Boston University bid for a jar of coins. 

This and similar experiments are described in the eponymous book, The Winner’s Curse, by Richard Thaler, 2017’s winner of the Nobel Prize for economics. Professor Thaler is one of the stars of the study of behavioural economics, the branch of the dismal science that explains how people’s behaviour can lead to odd – in the jargon of economics, ‘sub-optimal’ – outcomes. 

So the winner’s curse tells us that winners are often cursed as losers because they pay too much, an outcome often observed in real life. Perhaps the most famous example occurred in the UK in 1990 when the government auctioned five licences to provide 3G mobile telephony across the country. The auction process was a variation on the so-called ‘simultaneous ascending’ model, where competing bidders know what each other is bidding over an auction that will last for as many rounds as are needed to reduce the number of bidders to one per licence. 

Certainly, the timing of the auction was wonderful for the seller. The late 1990s technology boom was in full swing – though hindsight tells us it had peaked – so the prospect of winning mobile spectrum that would permit high speed transmission of internet data was seductive. In the end the five licences generated auction proceeds of £22.5bn. It was an enormous sum, then equivalent to 2.5 per cent of the UK’s annual output and compared with proceeds of about £160,000 for the sale of four licences for the previous round of – technologically inferior – 2G licences. 

Almost as soon as the 3G auction had ended, the criticism arose that bidders were forced to pay too much. More likely, it was because it quickly became clear that the technology bubble had burst so subsequent 3G auctions elsewhere in Europe failed to raise nearly as much as the UK’s. 

Meanwhile, variations on the winner’s curse can be spotted throughout business and investment life. For instance, buy new shares offered by a high-risk oil explorer whose survival depends both on its only exploration project coming good and on a new management team taking over and you are playing an extreme version. If there is no telling from the outside whether the oil exploration will pay off, then every share price between zero and a feasible maximum, say 100p, would have an equal chance of coming about. Intuition might tell you that 50p would be the sensible price to pay. But then there’s the uncertainty that the new management will take over. Factor that in and you should pay less than 50p. In fact, for any given amount you might be prepared to bid, the uncertainty about the new management means you must pay less and that logic applies right down to zero, which becomes the only sensible price. 

Maybe such a scenario should be called the ‘loser’s curse’. Actually, that epithet is reserved for punters at the race track who place a big bet on a long shot at the end of the day in the hope of making good their losses. The trouble is, on average they just lose even more because that’s what long shots do – they lose. And that also sounds a lot like buying ‘penny dreadful’ equities. How do you work that one into next year’s village fete?

47: Elton John’s ‘Bicycle John’ costume – herd mentality

For the second time in this series our inspiration comes from London’s Victoria and Albert Museum. Previously – see Investors Chronicle, 29 July 2016 – it was to use a toy rocket to explain the Black-Scholes options pricing model. This time it’s to use a gaudy outfit worn by Elton John in 1974 to explain why investors are really just dedicated followers of fashion. 

Men’s fashions didn’t get more ridiculous than what was run up in the early 1970s, as this piece from the V&A’s fashion collection amply demonstrates. It was designed by Bill Whitten, who later made costumes for Michael Jackson and Lionel Richie. The lurex fabric is decorated with bicycle bells and reflectors, and the four-inch platform soles are covered with multi-coloured rhinestones. Just the sort of thing for the ‘Rocket Man’ to wear as he belted out Crocodile Rock on his US tour that year. 

True, this outfit took 1970s glam-rock fashions to nth degree. But it’s only an exaggerated version of standard dress in the discos of the time and one wonders how many of today’s IC readers, kitted out in something similar, did lasting damage to their ankle ligaments as they fell off their platform soles while trying to impress with their dance moves. 

Today, of course, these self-same chaps are slightly rounder and are full of sang-froid; far too sensible, too worldly-wise, too composed to be influenced by what’s in vogue. Oh yes? When they get into ‘investment mode’, revved up behind their spreadsheets and their on-line database in the hunt for the next 10-bagger they are still potential victims of fashion. 

And that should be no surprise. After all, fashion is ubiquitous. The 18th-century novelist, Henry Fielding, called it “the great governor of this world – it presides not only in matters of dress and amusement, but in law, physic, politics, religion and all other things of the gravest kind”. 

Of which one is investment. At a superficial level that’s beyond doubt. After all, everyone can recall the dot-com investment mania when fashion dictated that shares in any company vaguely linked to this exciting new thing called ‘the worldwide web’ would be scooped up. That caused enough damage when fashion smashed into commercial reality after a few smart investors stopped to ask how many dot-com companies could actually turn their bright ideas into revenues let alone profits. 

Yet it was nothing compared with the misery caused a few years later when bankers fell for the fashion of creating off-balance-sheet vehicles and stuffing them with securities known as ‘collateralised debt obligations’. That seemed great because somehow these things generated high yields with little risk. And on the other side of what would become the mightiest financial mess in 120 years low-income consumers borrowed more than they could afford because their friends and neighbours were doing it. 

The 2008 global financial crisis happened when fashion became indistinguishable from social pressure. Because everyone else was at it in the US, Mr and Mrs Slightlybelowaverage felt it was okay to raise a second mortgage to pay off their credit-card debt (possibly sensible); then they thought it was fine to raise a mortgage on a Florida condominium because, said the broker, you just can’t lose money on those things; then, frankly, it would have been stupid not to buy another condo in that development because Julio and Jean had done just the same and theirs was already up 20 per cent. And so it went. Such things are madness and a little voice inside the brain says they’re madness, but – hey – everyone else is doing it, so it’s got to be okay, hasn’t it? 

The truth of the normalisation of madness was formalised in a disturbing series of experiments conducted in the early 1950s by a US psychologist, Solomon Asch. These showed how the opinions of a group could control the opinions of its individual members even when it was blatantly clear that the facts on which the views were based were wrong. As a group grew bigger, then the inclination of an individual to voice opinions that contradicted the group diminished and vice versa. 

In effect, Asch’s experiments, which form the basis of the ‘Asch paradigm’, quantified one of the most famous quotes of investment literature, that of the Scottish writer, Charles MacKay, in his 19th-century classic, Extraordinary Popular Delusions and the Madness of Crowds. MacKay wrote: “Men, it has been well said, think in herds; it will be seen they go mad in herds, while they only recover their senses slowly and one by one.” 

In mathematics, such propensities were melded into models of epidemics, which – as well as showing how a contagion spreads – can explain how fashion flares and stock prices soar. Basically, it depends on the pace of potential carriers (would-be buyers) becoming infected (buying) at a rate that exceeds the ‘removal rate’ of carriers (the number of sellers). When the infection rate – the inclination to buy – exceeds a threshold then conditions are right for an epidemic that, on a graph, will show a hump shape as new infections soar and then decline as the disease consumes its possible victims. 

The Nobel Prize-winning economist, Robert Shiller, tweaked this into a model specific to financial markets where he juxtaposed smart-money investors against blockheads, the ones who swung with fads and fashion. Smart-money investors hold shares for the right reason – ie, they correctly discount future cash flows to their present value. Blockheads hold shares for who knows what reasons, except they’re the wrong ones. However – and here’s the mathematical tweak in Shiller’s model – a stock price is formed not just by the smart investors discounting future cash flows correctly but also by their need to guess the inclination for blockheads to buy the stock. Since the smart investors have finite resources they can only bring ‘rationality’ – defined by a conventional cash-flow equation – to bear to a limited extent. The more that the blockheads’ resources outweigh those of the smart guys, the more that prices are shaped by frippery. 

As a mathematical construct, Shiller’s equation does a job – the infection rate in the epidemiologist’s model and the influence of blockheads in the pricing model are one and the same. Yet as an explanation for the observable movements of stock prices it falters because it knocks against the immovable barrier that no one knows what is the correct value of a stock, other – that is – than the price the market sets. 

Unlike fashion, that truth won’t change even though it won’t get us very far – much like trying to walk in those platform soles.