While studying at Harvard Business School, I recall one of the professors presented a simple auction that produced stunning results. The auction was for a normal US$100 bill and the rules were very simple.
- Silence is in effect (to prevent side agreements and coalitions forming)
- Real money (both bids and winnings)
- First bid must be $5, and bids go up $5 at a time
- You cannot bid twice in a row
- Highest bidder gets the $100 for his/her bid
- Second highest bidder pays his/her bid, and gets nothing in return
Where do you think the bidding finished? I should note that the Harvard classroom was comprised of smart individuals including CEOs, senior managers, physicists, aeronautical engineers, investment bankers, asset managers, etc.
So where did the bidding finish? US$240. If you calculate the numbers, the professor sold a $100 bill for $240 and made $375 ($240 – $100 + $235) in a few minutes. We later learned that the professor’s average highest bid for this auction is between $200 and $500, and has at times exceeded $2000.
Why Would Anyone Pay $240 or $2000 for a $100 bill?
The game dangles a potential profit of up to US$100 in front of the bidders, so the profit is no illusion and no one is forced to make a bid. Therefore, a rational player shouldn’t lose. Yet, one could say the players who bid up a dollar too many times its value must be acting irrationally.
Without diving into Game Theory and Rational Choice Theory, this auction provides a great, yet simple example of how easily a person’s rational judgement can become irrational. Once the $100 point is breached, it becomes a two-horse race between the first and second bidders, and what starts out as a game of easy profit is soon taken over by factors of Ego and Loss Aversion.
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To mitigate irrational decision-making within your firm, routinely ask these simple questions:
- What are our firms risk limits, risk controls and risk frameworks?
- Are we allowing any single individual the potential freedom to make irrational decisions?
What risk managers can take away from this experiment is that through implementing formalised, predefined risk structures, you greatly reduce the likelihood of irrational decisions. If you find yourself at a function with at least 8 – 10 people, give this experiment a try and see the results. We are expecting it will be profitable for you.
Founder and Managing Director of R3 Analytics, Liam O’Brien has considerable experience and knowledge in trading and risk management across multiple asset classes, developed over more than a decade in the financial services industry. Liam began as a proprietary trader in the industry and has since held roles in funds management, electronic trading, quantitative trading and risk, and broader investment banking. He has an intimate understanding of managing risk across all business units and a full appreciation of the role financial technologies serve in making forex trading firms successful. Liam studied at and is a graduate of Harvard Business School.
Email or call +61 2 8188 4400 for risk management consultation and solutions.