Auction Approaching

by Stubborn Mule on 12 December 2008 · 13 comments

Recently I bought a new house at auction and now I am in the process of selling the old house, which will also be by auction. As a result, I have spent a lot of time of late pondering the best way to approach an auction, both as a buyer and a seller.

There are a lot of different types of auction. In a Dutch auction, popular at wholesale fish markets and also known more prosaically as a descending price auction, the auctioneer starts with a high price, which is then reduced in increments until a buyer is prepared to pay that price for the fish (or whatever is being sold). Bond market tenders are closely related to Dutch auctions.

Another type of auction is a sealed bid auction, where buyers submit a single secret bid to the seller and the highest bid wins. I seem to recall that property sales in Scotland are something like a sealed bid auction (Scottish readers, please correct me if I have that wrong). Sealed bid auctions are also used in the bond market when investors are trying to sell illiquid bonds. In this context, the process is known as a “bid wanted in competition” (or BWIC) and banks will provide the investor with a single bid invisible to the other banks.

One problem with sealed bid auction is that bidders may be concerned about over-bidding, since they do not know what anyone else will bid, and may therefore place lower bids. The economist William Vickrey came up with a variant of the sealed bid auction designed to address this problem. His solution, known as the second-price sealed bid auction or Vickrey auction, still awards the auction to the highest bidder, but the bidder only pays the price submitted by the second highest bidder. The aim is to encourage buyers to bid the maximum price they are prepared to pay, with less fear of over-paying. Although popular with academics, Vickrey auctions are rare in practice. Still, given how bad liquidty is in bond markets today and how cautious banks are when providing BWIC prices, perhaps Vickrey auctions would be a good idea.

The most common type of auction is the English auction, also known as an ascending price auction. Bids at an English auction are made publically, increasing progressively until no further bids are offered and the highest bidder wins the auction. Typically English auctions are subject to a reserve price below which the vendor is not prepared to sell. If bidding does not exceed the reserve price, there is no sale.  Australian property auctions use the English auction system and also adopt the practice that if the reserve price is not met, that the highest bidder has the first right of negotiation with the vendor to attempt to agree a sale price.

Before my recent house purchase, I spent a lot of time thinking about the best bidding technique and now that I am about to sell, I am thinking about how best to set a reserve price. When it comes to bidding techniques, I suspect that most of the time technique is irrelevant. Most people approach an auction with an upper limit in mind and either your limit is higher than everyone else’s limit or it is not. However, people are emotional and not everyone will stick to their limit. In the heat of the moment, with the property of their dreams apparently in reach, a bidder may stretch past that supposed upper limit. The primary aim of any auction bidding technique is to stop this happening. A popular approach is to wait until close to the end of the auction, when the bidding has all but run its course, and then jump in with a firm bid. The idea is that the other bidders, who though that the property was almost sold, will be dispirited by the appearance of the new bidder and will be discouraged from further bidding. Advocates of this approach often go further and recommend waiting until the auctioneer announces that property is “on the market” (i.e. the reserve price has been reached).

The problem with the bid last approach is that everyone seems to want to use this technique. As a result, at a number of auctions I have attended recently, no one wants to start the bidding and so the auction takes a painfully long time to get started as the auctioneer desperately tries to drag a bid out from the potential buyers. So, I decided to adopt a different approach. My aim was to appear to be an extremely confident bidder who was not prepared to be outbid. To achieve this I wanted to have the opportunity to make as many bids as possible, so I decided to start the bidding straight away at an almost ridiculously low price. The auctioneer appeared shocked first by how quickly bidding started, but then by the very low start. He attempted to brush off the bid as too low, so I simply shrugged and stepped back. Obviously keen to get the process moving, the auctioneer decided to accept the bid after all. The low price quickly attracted other bidders and after every other bid I immediately followed with a counter bid. In making these bids, I stepped up in smaller increments than the auctioneer was looking for but again, while trying to talk me into higher increments (“you won’t impress anyone with a bid that small”), he would never reject a higher bid. The aim of this exercise was simply to be very visible with my bidding. As the bids rose, the other bidders started to get nervous and partners had intense whispered conversations to determine their next bid. But again, when they did come up with a bid, I simply bid again without hesitation. Of course I had my own limit, but the plan was to bid as though I would never stop right up until I hit the limit and then simply stop. Whether it was the success of the technique or not, I ended up winning the auction, although the reserve was not met and so there followed an hour and a half of negotation with the vendor (via the intermediary of the agent) before we finally bought the new house.

Compared to selling, that process now seems quick and easy. Selling is far more stressful. Our auction is next week and we are yet to decide on a reserve price. While we have a good idea of the minimum amount we would accept, and we certainly would not set the reserve any lower, the question is whether it would be sensible to set the reserve higher. One line of reasoning is to set the reserve low to ensure that the property gets onto the market during the auction and then let the heat and enthusiasm of an auction where the property will definitely sell do the work to push to the highest price. On the other hand, it may make more sense to set a higher reserve in an attempt to take advantage of anchoring bias. The idea here is that if the property passes in (i.e. the reserve is not met) and we proceed to negotiate with the highest bidder, that bidder is then informed of the reserve price. While they will not want to pay that price, it may anchor their expectations of a fair price. Regardless of how realistic the reserve price, a bidder negotiating a price below the reserve will tend to think that they got a good price. So a higher reserve could tempt someone to pay a higher price than they would otherwise have reached if the auction completed with a lower reserve.

I have yet to decide which of these two theories I favour and, since I have brought up the subject of cognitive bias in decision making, I would have to concede that it feels even harder to make a rational decision about selling your house than about buying one. If anyone has any suggestions, I would welcome them!

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{ 13 comments… read them below or add one }

1 Marc Lehmann December 16, 2008 at 7:26 am

The thing that has always troubled me with the English auction method is that as the seller you effectively only ever get a small gain on the second best bid. Effectively you get the second best price and will never know if the winner actually had a lot more up their sleeve.

2 stubbornmule December 16, 2008 at 3:49 pm

@Marc: you are absolutely right. This is the essence of my dilemma in setting the reserve. As you say, the winning prices will be slightly higher than the second best bid. This should mean that the winning bid is slightly higher than the second highest bidder’s limit. By setting a high reserve, the aim would be to try to claw back some of the difference between the second highest limit and the highest limit. The counter-argument would be that actually having the property go on the market may get the person with the second highest limit to go over their limit in the heat of the contest.

3 dan December 16, 2008 at 9:40 pm

that whole “first right of negotiation” thing is a crock, viz: http://tinyurl.com/6ypprb.

i auctioned a house last year (as executor of an estate – so i could view the process intellectually, rather than emotionally).

after an excellent campaign. and a number of contracts ordered. potential purchasers getting their builders/architects/mothers to look at the house the big day came.

we set a realistic reserve, which was in line with what the agent had been quoting folk who walked through the joint. it was a hard house to value because unlike say a paddington terrace or a suburban cottage on a standard block, it was a bit unique. i would not have been surprised if it sold for $1.5m or $2.2. which is quite a range. i set the reserve at $1.7m.

then the auction opened up. not a bid. not a single bid. everyone just stood back and waited to see what would happen.

finally the auctioneer broke the silence. came and had a chat with me and offered a vendor bid at $1.6m. still no bids. then the agent took me aside and asked me if i wanted to put the house “on the market”. which i did. the auctioneer got a bid for $1.62m. going once… going twice… going three times… sold to the only bidder.

now i don’t know what general lessons one can learn from this except: (a) thank god the vendor bid was at $1.6m and not $1.5m; and (b) in this strange and crazy market i think you gotta play it straight – otherwise you might end up like our good friend who often wins his own ebay auctions…

see you on friday.

d

4 GPat December 18, 2008 at 2:42 pm

Sean – isn’t an eBay purchase basically a Vickrey auction?? – qt least a variant when you bid your highest price but pay only a bid increment above the second highest price? I’m not sure i trust eBay to manage this process “properly”

5 stubbornmule December 18, 2008 at 3:37 pm

@GPat: eBay options are essentially English auctions: the bids are public and the price keeps rising until the bidding stops. The twist on eBay is that you can enter a single limit and have your bids placed automatically with the smallest possible increment. Nevertheless, there is still a bidding process, even if much of it is automated. The differences between this sort of auction and a Vickrey auction are that the Vickrey auction bid is not public (you get no information when placing your bid as to where other bidders are) and you are only allowed a single bid. In an English bid, you start bidding low whereas, in theory, with a Vickrey auction you will put one bid at the maximum price you are prepared to pay.

6 Marc Lehmann December 18, 2008 at 3:48 pm

Actually eBay is a hybrid of English Auction and Sealed First-Price Tender. The time line approaching zero being the end of the auction forcing bidders to make one final bid which becomes very tender like and sealed by the nature of the eBay application not giving bidders time to see the latest highest bid in the final seconds. The request of their servers isn’t returned to the bidders browser quickly enough that they can read and submit a new bid before the auction closes. So the participants don’t really know what the final bids are that are made in the final few seconds. In this environment your ISP connection speed, keyboard skills and timing become important factors. The sum effect of which is undisclosed pricing like a Sealed First-Price Tender.

7 stubbornmule December 18, 2008 at 3:58 pm

@Marc: You make a good point, vindicating GPat!

8 stubbornmule December 18, 2008 at 3:59 pm

I should also add that last night we sold our house, so I can stop obsessing about auctions now!

9 Marc Lehmann December 18, 2008 at 4:12 pm

I saw it on twitter and read it as mixed emotions and relief so I didn’t want to throw in an inauthentic congratulations. So if you are happy Congrats! :) My condolences otherwise ;)

10 stubbornmule December 18, 2008 at 4:20 pm

@Marc: the price was at the lower end of our expectations, but it was a price we had agreed beforehand we’d be happy to take. More than anything I’m glad it’s all over!

11 dan December 18, 2008 at 10:13 pm

mazel tov. see you tomoro

12 Sue February 22, 2009 at 7:30 am

But you never told us how you set your reserve! Obviously if you sold the house it worked to a certain extent, but did you feel that you made the right decision about what the reserve should be?

13 stubbornmule February 24, 2009 at 7:56 pm

In the end we changed our reserve during the auction. While this is probably not the most effective strategy, we’d originally set the reserve a little higher than the lowest we would accept. When the bidding came to a halt below the reserve, we agreed to lower the reserve to our minimum. The agent was hoping that putting the property on the market would prod a third bidder into play. This didn’t happen and the house sold at that the new reserve. So I’m glad that we didn’t set the reserve below our minimum just to try to put some life into the bidding! So overall, an acceptable, but not fantastic result. The property settled yesterday and I’m very glad it’s all behind us.

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