A Knight’s Tale! - Posted by David Butler
Posted by David Butler on May 15, 2008 at 09:39:48:
The two posts you’ve made in your thread are quite interesting, and fortunately, you don’t have to do a great deal of figuring to sort out the dilemma you present here.
When I first spotted your original post, my instinctive response was the same that Mike Morrongiello actually gave, with regard to the decision making process if buying for yourself.
To add a little “spit-shine” to it… In a scholarly paper written in 1961 (when economists were only starting to get a sense of game theoryâ??s importance), Columbia University economist William Vickrey used game theory to analyze auctions - and his brilliant study of auction strategies is seen as the pioneering paper in the field of auction theory. Ultimately, he concluded that the optimal bidding strategy is also the simplest… just bid the amount at which YOU value the object. Ahead of its time, Vickery’s theory was relegated to an obscure journal and overlooked for years.
I first became interested in game theory and auction bidding as a result of my time as a private contractor field manager-appraiser for HUD’s property disposition unit in California’s Central Valley. In that role, I witnessed “auction fever” and how it worked to cause bidders to overpay for HUD repo properties, to the point they could have purchased similar properties right next store for less. As we worked through the major real estate crash in the early 1980’s, I saw the phenomenon repeated over and over again at many public bank repo auctions, similar to what is happening today, once properties become REO (interestingly enough, auction fever doesn’t seem to affect public foreclosure auctions when the property is first put up for sale BEFORE the lender gets it back!)
Over the years, I became acquainted with Frank Knight’s seminal work (Risk, Uncertainty, and Profit), which was first published in 1921. This led me to explore other writings, further leading me to become familiar with more credited writers, including reknowned Princeton economist John Nash Nobel Prize , Hungarian mathematician John von Neumann, and the University of California’s John Harsanyi (who developed a method to do Nash equilibrium analysis even when players have incomplete information about each other’s values). Nash and Harsanyi shared the Nobel Memorial Prize in Economics with another game theorist Reinhard Selten, of the University of Bonn (Germany) in 1994 “for their pioneering analysis of equilibria in the theory of non-cooperative games”.
Over time, I developed modules in various of my private note investing workshops in relation to business planning, and investing as well, only using the auction process as a way of showing examples to offer explanations on various concepts of “auction fever”, “winner’s curse”, “prisoner’s dilemma”, “disappointment aversion”, and “great expectations”.
In the end, Vickery’s optimal solution, with a dose of Knight’s two step approach to dealing with the uncertainty of working with incomplete information (1. forming your best estimate of value for a given action, and 2) formulating your best estimate of that value actually being realized if you take THAT specific course of action), is generally the best way to approach your bidding process.
We are faced with that process daily in making offers on notes and real estate. For us, our approach is to pay what we feel it is worth, regardless of what other “offers” are supposedly out there. We never sweeten a bid based on what somebody else is supposedly willing to pay.
Hope this is of some help to you, and best wishes for your success in the Bidding Wars! And…
Have Fun For A Living
David P. Butler