Reflections On Getting Filled

I had a little financial adventure this week that’ll I’ll try to connect to some broader concepts in the Masochism section.

My wife’s sister’s family lives next door. We removed part of the fence so we have our own little commune with 3 generations living together. It has been the largest life upgrade I can think of.

The catch: it’s temporary — both families are renting.

We aren’t actively looking for a house to buy, but we asked our friend whose also the realtor who sold our house for us to just keep an eye out for “situations that could accommodate both our families”.

We got a call this week. She has a client selling a house that hasn’t been on the market for 50 years. An old 3/2 near the elementary school on half an acre. Oh yeah, and they are also selling the completely undeveloped flat half-acre lot behind them (there’s an easement making this back parcel a “flag lot”).

By offering the lots separately they are able to draw a wider buyer pool. But also makes the deal hairy. If you just want the front lot, you will be reserved in your bidding because you know at some point there’s going to be a house built in your backyard. Who wants to live next right next to a construction project for 2 years?

But this is also tricky for the person who buys just the vacant parcel. The 3 adjacent neighbors and the family who buys the lot with the house are going to NIMBY the permit and building process. Not to mention, that you need to pull utilities to the vacant lot (estimated to be about $150k).

The ideal buyer would want to lift both lots presumably with a plan to live in the old house while they build a new house. But that is a tiny buyer pool — population us.

We bid on both as a package. Because of the complications described earlier, the parcels aren’t selling immediately. We made a cash bid below the sum of where the legs are bid with the sense that the sellers know if they fill a single leg, it will be harder to fill the other and we were the clean option.

We would find out the next day if our bid was accepted.

I’ll bring you into the discussion of risk we had that night as we waited.

We believe our bid had a margin of safety of about 25% below fair value based on comps (comps for the vacant lot are higher variance and indirect — basically backing out land value from the price of teardowns and near teardowns). Building is a hairy proposition around here so even though you shouldn’t expect a builder’s margin, there is some margin which I describe as the market’s “Here’s a carrot, I dare you to upend your life to navigate the labyrinth of CA construction”.

We didn’t expect to get win the bid. Even though the bids for the individual lots were shakier because of the total dynamic, we were still bidding well below them. But what if we did?

I’d actually be concerned. Since the fair value of the lot with the house was easily-comped, getting hit would tell me the vacant lot had a landmine if it isn’t purchased by say, a direct neighbor (where we assume the individual lot bids came from). What if the direct neighbor was bidding for the lot because they just wanted more space (or a pool/tennis court, etc)? If we got hit perhaps it’s because the utilities are way more expensive to pull (I have a friend that owns a bunch of SFH’s in town and told me a story of how the water utility wanted $750k to feed a hillside parcel).

In short, if you bid below the sum of the legs and you get filled, you need to update your prior of what fair value is. We had a few knowledgeable friends including a local builder lined up to walk the property with us in the event that we get our bid hit. I was planning to be down at the permit office learning what I could this coming week, ready to ask the utilities about “worst case scenario quotes”, and primed to talk to insurance companies (Allstate and State Farm who make up the bulk of CA property insurers have stopped underwriting new policies in the state as of this summer— this is a whole other topic that gives me black swan vibes — well grey swan if I can see it guess). In short, we fired out a bid knowing we could back out risklessly. If we got filled it would be a highly restrained win until we investigated the risks more closely.

As expected our offer bid was not accepted.

The meta-risks above exist wherever deals are made.

Adverse selection

There is a lot of money floating around the Bay Area, a shortage of supply, and multi-generational relationships that we are not insiders of(we’ve been here close to a decade only). Given our relationship with the broker and the hair on this deal, we felt some of that was mitigated but probably not all. After all, our limited knowledge of the neighbors is a soft underbelly in our reasoning.

The catchy name for this concept is the “market for lemons”. Its strongest form contends that all used cars are overpriced according to the logic here. As a matter of practice, I suggest using that heuristic as the default but seek to disprove it because there is always the possibility of an inefficiency in your specific situation. It would be worthwhile to consider what conditions would make your situation more or less likely to lend itself to adverse selection.

Whenever you compete for a deal you must understand where you stand in the pecking order, who else has seen the deal, and what their passing on it might be saying.

Winner’s Curse

Fair value is not what you think conditional on getting filled. In Ben Orlin’s book Math Games With Bad Drawings, he discusses the value of playing auction games:

Because everything has a price, and auction winners often overshoot it.

We live in a world on auction. Photographs have been auctioned for $5 million, watches for $25 million, cars for $50 million, and (thanks to the advent of non-fungible tokens) jpegs for $69 million. Google auctions off ads on search terms, the US government auctions off bands of the electromagnetic spectrum, and in 2017, a painting of Jesus crossing his fingers fetched $450 million at auction. Before we dub this the worst-ever use of half a billion dollars, remember two things: (1) The human race spent $528 million on tickets to The Boss Baby, and (2) it’s a notorious truth about auctions that the winner often overpays.

Why does this winner’s curse exist? After all, under the right conditions, we’re pretty sharp at estimation. Case in point: In the early history of statistics, 787 people at a county fair attempted to guess the weight of an ox. These were not oxen experts. They were not master weight guessers. They were ordinary, fair going folks. Yet somehow their average guess (1,207 pounds) came within 1% of the truth (1,198 pounds). Impressive stuff. Did you catch the key word, though? Average. Individual guesses landed all over the map, some wildly high, some absurdly low. It took aggregating the data into a single numerical average to reveal the wisdom of the crowd.

Now, when you bid at an auction — specifically, on an item desired for its exchange value not for sentimental or personal reasons — you are in effect estimating its value. So is every other bidder. Thus, the true value ought to fall pretty close to the average bid. Here’s the thing: Average bids don’t win. Items go to the highest bidder, at a price of $1 more than whatever the second highest bidder was willing to pay. The second-highest bidder probably overbid, just as the second-highest guesser probably overestimated the ox’s weight.

To be sure, not all winners are cursed. In many cases, your bid isn’t an estimate of an unknown value but a declaration of the item’s personal value to you. In that light, the winner is simply the one who values the item most highly. No curse there.

But other occasions come much closer to Caveat Emptor: The item has a single true value which no one knows precisely and everyone is trying to estimate.

I like an example from Recipe For Overpaying: investor Chris Schindler explains why high volatility assets exhibit lower forward returns: a large dispersion of opinion leads to overpaying. He points to private markets where you cannot short a company. The most optimistic opinion of a company’s prospects will set the price.

Getting filled in an auction should make you update fair value. In Laws of Trading, Agustin Lebron gives an example from the market-making context. He starts by echoing what we know about the winner’s curse — any bidding strategy requires the bidder to estimate the item’s fair value conditional on having won the auction. This requires estimating how many bidders and how wide their uncertainty is regarding the item. But the problem is that some bidders are better informed than others. So if you are relatively uninformed and win the auction you are sad. [This topic came to life constantly to anyone who came to the StockSlam sessions — Steiner generously joked that if you traded with the Kris bot, you track down the info that shows how you just got arbed.]

But Agustin then gives an example of how to Bayesian update:

You may interpret a market maker’s width as an expression of confidence and using that to update your fair value by weighting their mid-price by the confidence.

If I’m 54.10-54.30 and you are 53.50-53.90 then I’m 2x as confident. So my new fair value is 2/3 x 54.2 +1/3 x 53.70 = 54.03

My Bayesian analysis of being filled on a limit order vs market order

Imagine a 1 penny-wide bid/ask.

If you bid for a stock with a limit order your minimum loss is 1/2 the bid-ask spread. Frequently you have just lost half a cent as you only get filled when fair value ticks down by a penny (assuming the market maker needs 1/2 cent edge to trade). But if you are bidding, and super bearish news hits the tape (or god forbid your posting limit orders just before the FOMC or DOE announce economic or oil inventory), your buy might be bad by a dollar before you can read the headline.

If you lift an offer with an aggressive limit (don’t use market order which a computer translates at “fill me at any price” which is something no human has ever meant), then your maximum and most likely loss scenario is 1/2 the bid-ask spread.

Do you see the logical asymmetry conditional on being filled?

Know what you’re leaning on

When you are a market-maker and you get filled it’s because your bids and offers are conditional on other bids and offers in the market. My bid in XLE might be pegged to the market’s bid for OIH. This is known as “leaning on an order”. My model has some value for the spread and if I get filled, I’m presumably able to leg the spread at a price I’m happy with. If I didn’t think I could leg the spread, I’d adjust my bid for XLE.

In real life, I might bid for a house but there’s still some conditional peg in place. If the stock market suddenly dove on a surprise 75 bps rate hike, I’d pull my house bid. It’s stale. The world and my assessment of the house’s value has changed. The period that defines staleness differs depending on whether you deal in real estate or HFT but the concept persists.

[This actually happened to us when we were in contract to sell our TX property last year. I had to act pissed when the realtor said the buyer’s financial advisor suggested they pull the bid when the stock market nosedived in the spring, but secretly, I thought “good advisor”. He was very right. We ended up selling the house nearly 10% cheaper].

The key is to always keep the reasoning for the price you bid or offered fresh. If you lose sight of why the price you are bidding makes sense, then your decision is no longer linked to an auditable chain of logic where you can go out and test the assumption (ie for example if you tried selling some OIH you might find the bid isn’t real or unusually thin and therefore your XLE bid might be “propping up the market” and the OIH bid is just leaning on you — it just has a different assessment of the spread value between the 2 stocks). Once you lose the chain of logic, you’ve lost the grip on the kite. Your bids will just float capriciously in the winds of emotion, narrative, and behavioral biases.