W is for Winner’s Curse

The Winner's Curse occurs when in order to win a competitive pricing situation such as an auction we overpay. By overpaying we destroy the investment case for buying in the first place and the losers turn out to be the winners. Of course, overpaying for anything is unfortunate, but competition has strange effects on our brains.

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Unfriend Those IPOs

Money Losing Ventures

The downward trajectory of Facebook’s price after its Initial Public Offering (IPO) wasn't a great shock.  Perhaps the bigger surprise is how many column inches have been spent analysing a story that can be summarized as “high price, low earnings, uncertain future”.  Sentiment is a powerful driver of stock prices, but only when there’s money around to back it up.

In fact IPO’s do seem to be generally subject to overpricing, which isn’t as obvious a trend as you might expect, given that owners tend to retain large stakes and to look for ways of retaining control of their precious creations.  For most retail investors, though, IPO’s are probably best avoided on principle.  The principle being not losing money.

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Limit Orders, on the Crumbling Edge of Behavioral Finance

Crumbling Limits

Although behavioral psychology has helped explain some of the odder effects around investment there remain many sceptics. The reason for this isn’t hard to find, because if you start out assuming that peculiar features of investment markets are caused by rampant misbehavior then you’re quite likely to find evidence to support that assumption.

Some of this is down to irrational behavior, no doubt, but perhaps not in the way that the academics first thought. So, for instance, consider the use of the humble limit order. Used unwisely – which is to say, nearly always – it doesn’t just lose investors money but ruins the researchers’ results into the bargain. Just watch those behavioral biases crumble away.

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Are IPO’s Bitter Lemons?

In Used Car Dealers We Trust

The Initial Public Offering (IPO) market exposes investors to a classic problem of asymmetric information: there’s not much doubt that the insiders know far more about the true worth of their company than do potential purchasers. So, as outlined by George Akerlof in his classic treatise on the used car market, we would expect that the only companies on offer in this market should be the ones you really don’t want to buy; companies with sticky accelerators and malfunctioning brakes.

Traditionally there’s a way around this impasse, the use of trusted intermediaries whose skill and judgement can be relied on by potential investors to overcome the urge of company owners to maximise their gains and who can distinguish the dross from the jewels. Bizarrely the result of this intervention supposedly sees companies floating at valuations below their real value but, unfortunately, this comes with the ever-present risk of abuse by trustees. Situation abnormal, as usual.

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