Who Won? – I Did. OR Did I?

By Alpha Research

Who Won? – I Did. OR Did I?

Sep 30, 2020

The Indian Premier League is flavour of the season. I would rather say a much-needed elixir for all the cricket lovers amidst the pandemic and the dwindling economic scenario. The players are auctioned and the most preferred player takes home a hefty booty. But does winning the most sought-after player generate the expected performance on the field? Yes may not be the correct answer every time. Pat Cummins, the most expensive and sought-after player in the current season of the IPL was hit for 49 runs off his 18 balls recently. So, readers, does the auction winner actually win?

This is popularly known as the phenomenon of Winner’s Curse. The bidder who wins an auction typically pays more than the asset is actually worth as repeated bidding results in overpaying for the asset, way more than the intrinsic value or true worth of an item. Regrettably, the winner’s curse is typically most often realised after the fact.

Without going into details of the concept of economic game theory, the winner seems to be ‘cursed’, owing to incomplete information and bidder’s emotions. At its core, the winner’s curse is a combination of cognitive and emotional friction. The buyer is victorious in owning whatever asset they are bidding on. However, the asset is likely worth far less in resale value after ownership due to different factors affecting the purchase and influencing its value in the future.

The asset may be an IPL player, a piece of art, real estate, jewellery or a stock! The stock market is also one big auction, where one bids and the highest bidder wins and is the owner of that financial asset.

Pricing of IPOs is often marred by the winner’s curse phenomenon. Companies want to sell their shares at maximum price. No wonder, IPOs come when stock market is in bull phase and when sentiment of investors are running high.

The recent changes by SEBI in the allocation of multi-cap mutual funds will push up the prices for many mid-cap and small-cap stocks. Everyone has commenced re-adjusting their portfolios to cherry-pick the most coveted mid & small-cap scrips. But is the overreaction leading to the price hike justified in the intrinsic values of these companies?

It is often argued that investors become excessively optimistic (pessimistic) about future news announcements after a series of good (bad) news and send stock prices to unjustifiable high (low) levels. Once subsequent news becomes known, it is likely to contradict this optimism (pessimism) leading to the correction of mispricing in the long-run.

As prudent investors, it is imperative to evaluate your BATNA – Best Alternative To A Negotiated Agreement. If your best alternative to winning the auction is to not win the auction, then tailor your bidding accordingly to head off the “need to succeed” at all costs. Thus, emotions, irrationalities, rumours, and other subjective factors can push prices far beyond their true values. To avoid becoming the next victim of the winner’s curse, follow these three principles:

Knowing the true value or the fair price of the asset you are bidding for is quite crucial before you even go for it. Appropriate research and analysis should be done to be clear in the mind, not get swayed and stick to the decisions made

Demarcate between your emotional mind and the rational mind. As soon as you start placing your first bid, you should know where to draw the line. This would help you hold your grounds more firmly.