It has been a relatively quiet week in finance so we thought we would write about a fun piece of research we came across recently. It is all to do with a financial phenomenon called ‘loss aversion’ and it also explains a basic human principle that we should always remember: financial competition is usually bad news for the competitors and should be avoided wherever possible.

We will come back to that. First, let’s describe the experiment. Renowned behavioural economist Dan Ariely wrote a book way back in 2017 called Dollars and Sense. His co-author was a comedian named Jeff Kriesler. In the book, the authors talk about an experiment Dan conducts with his students.

Dan waves a $100 bill in front of the class and announces that he will auction that $100 bill to any willing bidders. The auction has four rules. The first is that bids can only be made in lots of $5, starting at $5. The second is that that you cannot make more than one bid in a row. The third is that the highest bidder wins the $100 but they have to pay the amount they bid. The fourth and intriguing rule is that the second-highest bidder (that is, the ‘losing’ bidder), also has to pay an amount equal to their last bid – but they, of course, do NOT get the $100. If the winning bid is $70, the person who bid $65 also has to pay. But they do not get the $100. They just lose their $65.

Bidding starts and pretty soon someone bids $5. Very soon someone else will bid $10, and so on. Before too long, Dan the auctioneer is ahead. When someone trumps the $50 bid with a bid of $55, the auctioneer is guaranteed to receive $105 – $55 from the winning bidder and $50 from the under-bidder. But his costs are just the $100 for the $100 bill. He has made $5.

At this stage, the winning bid is $55. Many consider it to be a ‘no brainer’ to spend $60 to receive $100, so bidding continues. After not too much longer a bid for $85 is ‘trumped’ by a bid for $90. Now, things start to slow down. The $85 bidder realizes that another bid of $95 is not going to win – there will be a bid of $100 following straight after. By ‘upping’ their bid from $85 to $95, the next bidder actually increases their likely loss from $85 to $95. The way the game is going should now be clear, and it makes no sense for anyone to bid $95.

Except…

They almost always do! The $95 bid then gets trumped by a bid for $100. Now, things get really interesting. The $100 bidder is simultaneously relieved and annoyed. Annoyed that someone bid $95 and stole their profit, but relieved that they were able to ‘get out’ of the auction without being the second highest bid.

Except, again…

The auction hasn’t finished. There was no rule that bids could not continue beyond $100. The $95 bidder now bids $105. Yes, that guarantees them a loss, but they would only lose $5, not the $95 they had stood to lose. It is in some ways a rational bid. Except, of course, that even this is not the end of it. The $100 bidder now stands to lose $100. So, they bid $110, to reduce their loss to $10. Now the under-bidder faces a loss of $105. They go again, too.

The auction continues until someone realizes that they are in a lose-lose situation and they stop. At that stage, both bidders lose. The losing bidder just loses $95 more than the ‘winner.’

Dan reports that the highest price he has ever been offered was €590! Yes, Euros. That means he actually made more than €1,000 (he received €590 + €585, being €1175, and only paid out €100. (And yes – he insists that people pay him!) At this stage, one of the bidders has lost €490 and the other has lost €585. But they have both lost. Dan reports that there is almost always two losers like this. The bidding always goes well beyond the face value of the prize.

So, why do people keep bidding, even when the inevitable outcome of the bidding becomes so obvious to spot? The reason is that people really hate losing. Losing anything, really, but money especially. People will go to a lot of trouble to avoid a loss. And sometimes that trouble will cause even greater losses. In this case, the fact that the auction turns into a competition to see who loses more is also a key part of the problem.

This is a really key thing for humans to understand about ourselves – especially given how many things are held up to us as if they are a competition. Financial competition is usually bad for the competitors. This is why businesses try to avoid competition wherever they can. But people should, too.

Think of what is probably the biggest purchase most of us ever make – buying a house. If you buy at auction, listen closely to the way the auctioneer speaks. He or she (but usually he) will almost always use language like ‘winning’ the auction. He is trying to turn the bidding into a competition, because he knows people hate losing.

Of course, even if you buy a house at auction, you do not ‘win’ the house. You still have to pay for it! And, if you allow yourself to get too caught up in winning and losing, you might find you pay more than you needed to. The good news is that, for house auctions and most other real world auctions, the second highest bidder does not have to pay. Ariely adds that to his experiment to make the point more clearly: humans who cannot accept a loss end up losing more.

Indeed, we need to resist the idea that a house auction is a competition, and instead understand that it is simply a way to reveal something that already exists but is simply not yet known – the person prepared and able to pay the most for the house.  The buyer already exists at the start of the auction – we just don’t know who it is yet.

So, what would be the only way to ‘win’ Dan’s auction? The only way to ensure you make money is to get together with the other bidder/s and agree not to compete. Agree that there will only be one bid, of $5. No one else will get involved. This guarantees a win of $95 (the $100 note minus the $5 bid). The co-operative non-bidders can then split the $95 evenly between them.

Co-operation. Beats competition almost every time.