Sunday, February 14, 2010

Psychology at a Home Auction

I just attended an REDC home auction. I wasn't bidding; just there out of curiosity and to see how the process works. Warren Buffett has said that Berkshire doesn't participate in auctions, largely because of the concept known as the winner's curse. What I found most interesting about the process was the way the auction tried to use some psychology to get people ready and excited to bid before the auction began.

To set the tone of the morning, the auction played upbeat music to get everyone in a good, fun mood and to try and get everyone excited (maybe excited to overpay?). I showed up about 20 minutes early and entered the room to Phil Collins singing Invisible Touch. That song was followed up by Come On Eileen by the Dexys Midnight Runners, and then the song Smooth by Santana and Rob Thomas. And - to save the best for last - the final song that played just before the music stopped for the auction process to begin was James Brown's Living in America.

As the music was playing, there was also a presentation up on a big screen that was going through slides on how the auction process works, why it is good to buy a home through the auction process, and - in between every few slides - quotes from 4 well-known people. The 4 quotes were: 1) a Donald Trump quote about how great real estate is and how much he loves it (the word "love" was in the quote); 2) a quote from Andrew Carnegie about how 90% of all millionaires came through real estate; 3) a quote from Franklin Roosevelt that said "real estate cannot be lost or is about the safest investment in the world" (tell that to the people whose homes were being auctioned off for much less than they paid for them); and 4) a Henry David Thoreau quote about living the life you imagined.

Once it was time to start, someone who I think they said was the president of something come on to give an overview of things and introduce the guy he referred to as a "world champion auctioneer." During his overview, he told the audience that we are at the bottom of the housing market, we're currently heading into a recovery which was confirmed by an article he read in the Washington Post, that interest rates are near all-time lows and that might not last for long, and that owning a home is the American dream (again, tell this to the people whose homes were being auctioned off). He then ended his overview before introducing the auctioneer by saying/repeating "we are certainly at the bottom of the market."

As the auctioneer came on, he started by telling the audience that although things will go fast, don't be intimidated. He then did a practice run by pretending to auction off one of the auction worker's houses that he said was a 3 bedroom home in southern California. It should also be noted that the auction workers were all dressed in tuxedos and were excitable guys who look like they are having tons and fun and want to be your friend. The practice run ended, the worker's house was pretendedly auctioned off for $1 million, which they then showed on the screen as a truck with what was basically a wooden box built on the back. This of course got some laughs and got people to smile before the auction began.

Then the auction began. Their goal was to go through 25 homes per hour, so it was a quick-moving process. The first few houses went quickly but when the bid for a house was below what I think REDC wanted as a minimum, they were willing to wait longer for a winning bid to come in. I was there for a little over an hour after the auction began and would guess that about 15 homes were auctioned off. The workers in tuxedos moved around the room and applied a little pressure to bidders to try and get some competitive bidding juices.

It was a good learning process to see how an auction like this works. The auction really uses Cialdini's weapons of influence to try and get people to pay up and participate. From the 4 quotes mentioned above, the president who spoke, the auctioneer's title, and the Washington Post reference, you can see that the authority principle was very prevalent. The low starting bids and getting bidders to come with a cashier's check probably helps influence through the commitment and consistency principle. The comments about low interest rates not lasting and it being the bottom of the housing market uses the scarcity principle. The smiling, happy workers and fun atmosphere try to help influence through the likability principle. And the American dream comment and other comments made try and use social proof to get people more willing to bid. There are probably many other things at work, but the main point of all of this is probably that there is a good reason why people often overpay and experience "the winner's curse" at auctions. And the lesson is that if you ever do participate in an auction, make sure you have an estimate of value for what you're bidding on, you know the highest amount you're willing to pay for it, and then be disciplined not to go over that number, all while keeping in mind that there are plenty of weapons of influence that may be thrown at you to try and get you to increase your bid during the process.


Update (2/15) - Manish from India was kind enough to point me to a great excerpt from Charlie Munger on auctions from his speech "The Psychology of Human Misjudgment":

Finally, the open-outcry auction. Well the open-outcry auction is just made to turn the brain into mush: you've got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away... I mean it just absolutely is designed to manipulate people into idiotic behavior.

Then there is the Warren Buffett rule for open-outcry auctions: don't go.