Football, IPOs, and The Winner's Curse

The hapless Detroit Lions, the cause of endless frustration, may have done something right for once when they didn't pursue All-Pro defensive lineman Ndamukong Suh in a bidding war that was eventually won by the Miami Dolphins. Suh received a $114 million contract, $60 million of which was guaranteed.

Why do free agents in sports receive such enormous contracts that seem to defy reason? After all, as the website "FiveThirtyEight" points out, Suh's dominance as a player with the Lions may not be replicated in Miami. And even if Suh continues to be a great player, Miami may still have paid him more than he's worth.

 This phenomenon is known as "the winner's curse." It can occur in auctions where the value of the object being bid on is not truly known. The desire to win can push the successful bid well beyond the item's true worth. In the case of pro athletes, "the team that is most irrationally bullish on the player will be the most likely to sign him to a big contract." Thus, in an effort to win, you end up overpaying.

The winner's curse can also happen in the investment world as well. Initial public offerings (IPOs) are, in essence, auctions. As the "Wall Street Daily" describes it: "The item being auctioned is a private company. The investment bank is the auctioneer. And the investors are the bidders." The investment bankers are seeking the highest price for the company's newly public stock.

The problem arises because information about the new company is scarce. Research requires reading thick documents, something most investors assiduously avoid. Instead, investors typically rely on the hype surrounding the deal. The hype drives up the price at the time of the IPO, but the hype eventually fades as does the price of the stock, leaving the early buyers with an under-performing asset. (Yes, there are some successful IPOs that provide above-average returns, but these exceptions don't alter the fact that many IPOs fail to deliver acceptable returns for investors.)

Nothing is certain with respect to investments. But you can reasonably expect the Detroit Lions to disappoint.