When top dogs fall to being underdogs, watch out that you're not along for the ride. By Anne Kates Smith, Executive Editor From Kiplinger's Personal Finance, July 2013 What do Major League Baseball teams, today’s red-hot real estate market and the world’s biggest stocks have in common? They can all fall victim to the winner’s curse, an economic anomaly that occurs when the winning bid for an item exceeds its intrinsic value. According to the winner’s curse, bidders who overestimate an item’s value the most wind up winning the auction. Subsequently, they either lose money on the deal or don’t make as much as they expect.See Also: What Investors Can Learn from the Biggest Companies The concept dates back to the oil boom of the 1970s. Engineers realized that, given the difficulty of estimating the amount of oil that might be recovered from a parcel, the company with the highest estimates wound up paying the most for drilling rights. That often resulted in disappointing profits. If everyone had complete information and all bidders were rational, then no one would suffer from the winner’s curse. If you don’t buy this theory, try an experiment: Auction off your coin jar after counting the money in it. The average bid will be less than the value of the cash (because people are naturally risk-averse), but the winning bid will invariably be higher. Advertisement Real-life lessons. Economist Richard Thaler, of the University of Chicago, wrote about the phenomenon in The Winner’s Curse: Paradoxes and Anomalies of Economic Life. It seems especially relevant today, as home buyers in hot markets are enticed into bidding wars. Even if you plan to stay put for a long time, the winner’s curse could jeopardize your financing (if you can’t substantiate the home’s value with comparable sales) or limit your options in the future. In the stock market, the winner’s curse most often comes up in the context of corporate takeovers or initial public offerings. But Rob Arnott, CEO of investment firm Research Affiliates, thinks he sees the winner’s curse at work in a big way in the market’s biggest stocks. The largest stocks by market capitalization (price times shares outstanding) — or “top dogs,” as Arnott calls them in a study he coauthored — “are usually priced to reflect a view that they will remain on top, but they often don’t.” Top dog to underdog. Arnott has studied top dogs going back 60 years. He found that once a stock becomes the largest in its industry, it goes on to lag its peers over the next one-, five- and ten-year periods, roughly by an average of four percentage points per year in each of the time frames. The lone exception: ExxonMobil (and its predecessor companies), which Arnott found outscored its peers over rolling ten-year periods by an average of 0.3 point per year. Overall winners can turn into even bigger losers. The biggest stock in the U.S. market has trailed an index of 1,000 large stocks by an average of 5.4 points a year over subsequent ten-year periods. (We’ve had eight top dogs in the past 61 years, including AT&T and Microsoft; Apple became the biggest U.S. stock ever in August 2012, and has since tumbled more than 30%. This year, it has jockeyed for the top spot with Exxon.) Advertisement The biggest foreign stocks suffer the same fate. Arnott’s takeaway: Avoid top dogs. A portfolio of 488 stocks (the S&P 500 minus 12 industry top dogs) would have beaten the S&P by one percentage point a year over the course of the study. Fans might find the winner’s curse playing out with Major League Baseball’s free agents — those veteran players who on occasion are up for grabs to the highest-paying team. “There’s a tendency to think a player has reached a new plateau of performance because he was good last year, and that produces the winner’s curse,” says Stephen Walters, an economics professor at Loyola University (Maryland) who has studied the curse in baseball and advises the Baltimore Orioles. Something to ponder as we watch the All-Star game, tour open houses or trade glamour stocks. Anne Kates Smith is a senior editor of Kiplinger’s Personal Finance magazine.