The football transfer window is wide open, and it carries an important message for investors.
The point is that clubs often pay too much for players: think of Fernando Torres at Chelsea, Roberto Soldado at Spurs or pretty much anybody at Newcastle United in recent years. These, and many more, are examples of the winner’s curse – the tendency for bidders to pay too much.
This is an old phenomenon: Richard Thaler gathered examples of it 30 years ago. But it hasn’t faded away since then. One contributor to the tech crash of the early 2000s was the realisation that telecoms companies paid too much in the auction for 3G licences. Investors still tend to pay too much for newly floated companies. And companies often see their share price fall after they’ve taken a company over.
In his new book, Finance for Normal People, Meir Statman says this winner’s curse is an example of a more general mistake – a framing error. We think of investment in the wrong way, he says. We see it as a run in the park – a test of ourselves against the environment. But in fact, he says, it is a race against other people. Stock-picking is a zero-sum game: if I am to beat the market, somebody else must underperform. This means we must pay attention to other traders’ motives and behaviour, just as we must analyse our opponents at the poker table.
So, for example, we must ask: if this asset is so good, why is its owner so keen to sell? Just asking this would alert us to the possibility that he has private information which tells him the asset isn’t as attractive as we think – that a company is being floated now because its owners know that now is the best time to sell, or that a footballer is a lazy good-for-nothing.
Such awareness would protect us from the winner’s curse in another way, too. If we’re in a bidding war against many others, we’re likely to have to outbid somebody who is overconfident about his valuation of the asset – which almost guarantees us paying too much.
It’s in this context that we should interpret a recent finding by Brice Corgnet, Mark DeSantis and David Porter. They show that successful traders have good theory of mind skills. They are good at reading other people’s intentions and moods – a skill that helps them to know when somebody is selling them a pig in a poke.
All this matters for everyday stock-picking. Buyers must ask: if this stock is as underpriced as I think it is, why is the other guy selling it? Sometimes, he might know more than us. The fund manager who has time, analysts and access to company managers on his side might well know more about companies than retail investors – or at least if he doesn’t, we must ask why. The investment race, says Professor Statman, can be a rigged one; other runners are wearing running shoes while we’re in heavy boots.
You might think this is a reason not to pick stocks at all and to hold tracker funds. Certainly, this is what many experts do. A survey of finance professors by Colby Wright at Brigham Young University found that fewer than one-in-five say they try to beat the market with their own investments.
This inference, however, is not wholly correct. Sometimes, other investors have good reason to leave a share underpriced and so allow us to grab bargains.
For example, some fund managers who are judged on relative performance avoid defensive stocks because they fear these will underperform a rising market and cost them a bonus, reputation or their jobs. Retail investors don’t need to worry about this benchmark risk, and so can buy the shares some others are neglecting.
Also, some investors avoid cyclical stocks such as housebuilders or smaller companies because they are worried about the risk of recession – say because this would cost them their jobs or devalue their other assets such as property or their own businesses. Investors who can afford to take recession risk (say because they are retired) can then buy such stocks and so pick up the risk premia which others are avoiding.
In these categories of share, we might have good reason to buy as others have good reason to sell. For other stocks, though, this isn’t the case. And it might be you who is wearing the heavy boots and your counterparty the running shoes.
