Why we put an offer on our house at the asking price
If you've studied an asset and think it's too cheap, don't fool around with lowball bids or you'll expose yourself to adverse selection
When my wife and I bought a house this February, some of our friends were surprised that we put in an offer at the asking price, with the stipulation that the seller had 24 hours to accept. Conventional wisdom in some circles is that you should always bid 5-10% below the ask, even if you think a house is cheap. I got this reaction from enough people that I thought I'd write up a short note, based on my experience trading stocks, about why I think this is wrong.
Let’s talk about “adverse selection”
For the last couple years, I’ve been using data science for trading stocks, and here’s a common situation I’ve encountered:
I do a little math, and I realize that if buying a stock with certain characteristics at a certain price generally returns an average of 20%. So I go out and start buying all the stocks I can find that have those characteristics and trade at that price. But my actual real-world returns are much lower than 20%.
Why are my returns so much lower than I predicted? Because of something called “adverse selection.”
The market price of a stock—like the market price of a house—is “non-stationary.” It moves, sometimes very fast. If a stock gets truly cheap, it usually doesn’t trade at that price for very long. So there's a good chance that you won't even notice that a quality stock is trading at a discounted price before the price moves back up. And even if you do notice it, you may not actually be able to buy it at that price. Thousands of other buyers are also looking at the price and noticing how cheap it is, and they’re going to be bidding against you. By the time you put in your bid, the price may not be cheap anymore.
So the stocks you actually succeed in buying at your target price are often going to be the ones where there’s something wrong with the company—some damaging piece of information you’ve missed or overlooked that’s causing other buyers to turn away. In the whole universe of stocks, stocks with your target characteristics that sell at your target price continue to get a 20% return. But the ones you actually buy don’t do anywhere near that well.
Do lowball bids offer a “margin of safety”?
One strategy you might adopt to deal with the adverse selection problem is to give yourself some margin of safety. Let's say you think, “since I’m not actually getting 20% return at this price, I’ll set my buy order at a price that’s lower than that, to give myself a little breathing room.” So whenever a stock hits your target price, you put in a lowball bid to buy it somewhere below that price.
Counterintuitively, this may only make your adverse selection problem even worse. If there tends to be something wrong with stocks that stay at your target price long enough for you to buy them, how much worse will be the stocks that go even lower than that?
Worse still, your bid gives your counterparties and competitors time and information they can use against you. Your lowball bid sets a floor price that gives rival bidders confidence to make an offer at the ask. You might even set off a bidding war that drives the asking price even higher than that.
The end result is that with a conservative bidding strategy, you’re almost always going to end up with problematic assets. Maybe you’re getting a good enough price to offset the problems, and maybe you’re not. Since these are problems you’re unaware of, there’s no way for you to know if the discount you held out for is actually deep enough.
Mitigating adverse selection with aggressive bids
Instead of bidding conservatively, I think the way to mitigate adverse selection is exactly the opposite. If you’ve done your due diligence on an asset and you see it trading at a price you consider too low, you should bid aggressively and complete your purchase as fast as possible. In the stock market, this generally means I place a “market order” or even a “limit order” at a price somewhere above the asking price. In the housing market, it means that my wife and I placed an offer on a house at the asking price and required the seller to accept or decline it immediately.
Certainly, this means you might pay a small premium to complete your purchase quickly, though at the right price, that shouldn’t be a big deal. In any purchase, you also still may end up buying an asset that has problems you overlooked. The difference here is that your aggressive bidding strategy has brought the probability of undetected problems into line with the average for assets of this type that sell at this price. If you end up with a lemon, it will be because you happened to have bad luck; not because you structured your bidding strategy in a way that caused you to have bad luck.
The importance of having a “view”
You don’t have to read far in the behavioral economics literature to run across the concept of “psychological anchoring.” The basic idea here is that people “anchor” to prices they see in the market, and this causes them to make biased judgments and decision-making mistakes.
For instance, countless retail stores will set their “list” prices for merchandise 40% too high, and then constantly run “20% off” sales to make you feel like you’re getting a bargain. Unfortunately, this dirty trick actually works, and the stores that use it tend to make a lot of money. On the flip side, if you see a very cheap asset that used to be ridiculously cheap, you might miss out on the opportunity to buy very cheap because you’re holding out for a ridiculously cheap price that will never be seen again. Or you might buy an expensive NFT or beanie baby because it used to be even more expensive.
The advice to always bid 5-10% below the asking price of a house is a classic example of a psychological anchoring error. Had my wife and I followed that advice, we might have missed the opportunity to buy a beautiful house at a substantially better-than-market price.
This is where it’s really important to formulate your own personal “view” on the proper price of an asset. To formulate a view, you need to spend enough time on the market to see how assets are generally priced, and you also need to do some due diligence on the asset you’re buying and some thinking about what you’re willing to pay for different features. This will help insulate you from being too biased by the prices that others set.
In shopping for our house, my wife kept an eye on the housing market for several months in advance, so we knew generally what houses were going for in the place we wanted to live. The house we settled on was substantially nicer than houses selling for tens of thousands of dollars more. We formed our own view on what the house was worth, and we were happy to pay the asking price. Meanwhile, mortgage rates were coming down and spring was right around the corner, so we knew we’d have some competition from other buyers unless we moved quickly.
So that’s what we did.
