Perspective on global equity markets through a behavioral finance lens

The winner’s curse: The overpayment principle

Fall 2018

Key takeaways:

  • The winner’s curse is a behavioral finance effect that can lead your clients to pay more for stocks than their intrinsic values would suggest.
  • The characteristics that tend to define the Baby Boomer generation make them more susceptible to the winner’s curse than Millennials.
  • U.S. economic growth has been solid, rates have risen, the labor market has tightened, and corporate profits have been impressive.
  • However, prices for select growth stocks became excessive, paving the way for October’s market meltdown and challenging the longest U.S. bull market in recorded history.
  • Given the recent rise in volatility and reset in valuations, now might be an opportune time to speak with your clients about the potential benefits of diversification and periodic rebalancing.

Did the recent market selloff happen because some U.S. equity market investors were cursed? From a behavioral finance standpoint, research suggests so. Amid the ongoing competition to earn higher returns than fellow market participants, unwary investors can fall prey to an emotional behavioral finance effect known as the “winner’s curse.” As the market has demonstrated on multiple occasions within the last five years alone, when irrational exuberance replaces rational investing, price escalation can stretch stock valuations of even sound companies to the breaking point, ushering in a market meltdown.

Professor Richard H. Thaler, 2017 recipient of the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics, has frequently referenced the winner’s curse. One classic example demonstrating this effect suggests that an instructor in need of lunch money fill a jar with coins and auction it off to students. The high probability outcome is two-fold: (1) the average bid
will be considerably less than the value of coins in the jar, reflecting our innate tendency toward risk aversion; and (2) the student winning the jar will inevitably have overestimated its worth, with the difference providing a “free lunch” for the instructor.

In this edition of our quarterly behavioral finance insights, we discuss how the winner’s curse helped pave the way for the recent market selloff, discuss the return of market volatility, provide some generational insights to help deepen your value proposition with clients, and wrap up with some actionable suggestions to help advisors better prepare clients for a potential increase in market volatility.

The curse behind the recent market mayhem

From a behavioral finance standpoint, we believe that the winner’s curse was partially behind the run-up to the October market meltdown. Just as students can become caught up in the moment when bidding for a jar of coins, market participants can become irrationally exuberant when the equity market seems unstoppable. The effects of this year’s run-up are illustrated below, revealing the lopsided performance of growth-oriented sectors in the S&P 500® Index through September.


After stretching to one record high after another, the S&P 500 Index’s total return was 10.6% for the first nine months of 2018, a respectable performance by historical standards. Yet for perspective on the outperformance by growth-oriented stocks, returns generated by both the Technology and Consumer Discretionary sectors were nearly double that of the index.

When stocks become too disconnected from their underlying fundamentals, history has proved time and again that a market correction might be lurking just around the corner.

Recalculating the value vs. growth equation

When stocks become too disconnected from their underlying fundamentals, history has proved time and again that a market correction might be lurking just around the corner. Enter October, when the markets weathered a pronounced selloff that erased essentially all of the U.S. stock market’s gains for 2018. As the equity market sentiment turned bearish, the outperformance of large-cap growth stocks over value stocks—which was at multi-year extremes—began to correct.

This sudden shift prompted a spike in position hedging, which is reflected in the Cboe Volatility Index® (VIX® Index) chart below. After comparatively calm markets in 2016 and 2017, the resurgence in volatility probably shocked some of your optimistic Baby Boomer clients. Yet when looking through a longer-term lens, market ups and downs have historically been the norm, and the recent levels of market complacency the exception.


The traits that tend to define Baby Boomers mean that they likely sustained the highest casualties from the recent fallout from the winner’s curse.


Baby boomers: The susceptibility variable

Many of your Baby Boomer clients probably felt quite optimistic about their financial futures prior to October. Unfortunately, the traits that tend to define Baby Boomers mean that they likely sustained the heaviest casualties from the recent fallout from the winner’s curse. In part, this reflects Boomers’ propensity for high self-confidence and calculated risk taking. The Baby Boomer generation was hit particularly hard when the housing bubble burst too, and for similar reasons.

Moreover, in the final phase of a typical business cycle, investors seem to pay less attention to intrinsic valuations than during economically leaner times. Similar to how the wealth effect can push up economic growth prospects, record levels of consumer and investor confidence seemed to suggest to many Boomers that the U.S. bull market had more room to run. As demonstrated in the consumer sentiment chart below, Baby Boomer confidence has been rising for roughly the past five years, while Millennial confidence has been on the general decline since 2015.



Millennials: A relatively risk-averse generation

Unlike Baby Boomers, Millennials often question the prevailing wisdom and adopt contrarian viewpoints. As a result, your Millennial clients likely assessed the recent market environment critically, focusing more on the unlikely chance for the longest bull market in U.S. history to remain in full stride. Millennials tend to consider intrinsic stock valuations carefully, and when appropriate, look for more attractively priced opportunities elsewhere.

This generation grew up in the wake of the Tech bubble, with many Millennials directly confronting the aftermath of the Great Recession—and relative lack of jobs—early in their careers. This translated into a later overall entry point into their desired professions, giving rise to a more skeptical viewpoint on the potential benefits of stocks. As a result, Millennials tend to be more risk-averse than the average Baby Boomer. This also makes your Millennial clients far more predisposed to important conversations about the benefits of rebalancing and getting back to their previously agreed-upon asset allocations.

Opening up the present opportunity

The October reset in valuations has provided an opportunity to speak with your clients about the recent market volatility, reconfirm their risk tolerances, and assess their holdings in case behavioral finance biases have been negatively influencing their asset-allocation decisions. Solid U.S. economic growth, healthy third-quarter corporate profits, a continued slow rise in interest rates, and the lowest unemployment rate in 30 years form a solid foundation for U.S. stocks across many sectors.

On the horizon

The winner’s curse and other behavioral finance biases can lead your clients to make irrational investment decisions, potentially reducing their chances to achieve long-term financial success. Particularly for your Baby Boomer clients, a thoughtful conversation regarding the recent selloff might be in order. The benefits associated with developing a balanced portfolio built upon a diversified foundation, rather than a sector-heavy approach, can appeal to a variety of generations. After all, behavioral finance studies have amply demonstrated that people prefer to avoid losses approximately three times more than they desire gains. Staying invested in the markets over time is therefore a far more prudent strategy than trying to time the markets.

In addition, when speaking with your clients about rebalancing opportunities, remember that the final phase of the current business cycle is likely here, and that volatility may remain elevated compared with recent years. Other complications could include a further slowdown in global growth, and the potentially deeper consequences of the trade war between the U.S. and China. We believe that secular stocks of companies with a competitive advantage have the potential to perform well over the longer-term.


Omar Aguilar, PhD
Chief Investment Officer, Equities and Multi-Asset Strategies
Charles Schwab Investment Management

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