Thinking About Thinking

A Simulation Game: Cutting Your Losses

Posted in Pop Culture by larrycheng on November 16, 2009

One of my partners led an impromptu game in our team meeting today which illustrates the emotional tension of cutting your losses.  For any investor or operator who takes risk with capital, the concept of cutting your losses comes into play at some point.

The simulated game had these ground rules:

  1. Everyone would have the chance to make monetary bids for a prize. 
  2. You could always increase your bid after hearing other bids.  There is no limit to the number of revised bids you could make. 
  3. The highest bid after everyone had finalized their bids would get the prize – in this case my partner offered to pay $20 as the prize.
  4. The catch is if you are not the highest bid – you would have to pay him the amount of your highest bid.  So you could lose money. 
  5. He guaranteed he would theoretically make inordinate amounts of money through the simulation. 

So in a room of around ten folks, we started lobbing in hypothetical bids:

  1. I started with a bid of $5.00, just to see how things would go. 
  2. Another person bid $7.00. 
  3. Then another person offered $19.99 thinking that he could short circuit the whole process.
  4. Not wanting to lose my $5.00, it immediately occurred to me to offer $20.00 – which I did.   

Then all of us had the aha moment that for the person who bid $19.99, if he thought he could win the “auction” by bidding $20.01 – he would certainly rather lose 1 cent than lose $19.99.  And, then if he bid $20.01, I would have to decide if I was going to bid $20.02 for the chance to lose 2 cents rather than lose $20.00.  But, what if then the person who bid $7.00 decided to bid $20.03 for the chance to lose 3 cents instead of $7.00. And, eventually you could imagine a scenario where everyone in the room bids above $20.00 for what amounts to be a foregone conclusion where everyone loses money (except my partner of course). 

In a very simple way, this game illustrates the challenge of cutting your losses.  Investors face this in situations when they have to decide whether to invest more money behind a company that is decreasing in value.  Managers often have to face this when continuing to invest in business initiatives that are not tracking, but have taken substantial time and resources.  I think the lesson learned from the game is if you’re in a no-win situation, cut your losses immediately.  But, as the game illustrates, that is easier said than done.  And in the real world, it’s often hard to know if you’re truly in a no-win situation or not.

By the way, I would not have bid $20.02. 

8 Responses

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  1. FiscalStudent said, on November 16, 2009 at 4:48 pm

    This is whats known as a dollar auction, first suggested by John Von Neuman. Many more interesting concepts covered in the book about him called “prisoners Dillemma”

  2. Boston1630 said, on November 16, 2009 at 5:38 pm

    Could this descibe what happened to bill Belichik yesterday?

    • larrycheng said, on November 16, 2009 at 6:34 pm

      I’m not yet prepared to talk about what happened with Belichick. The wound is too raw. :) Actually, I may be one of the few that agreed with his call. But, that doesn’t mean the loss hurts any less!

  3. Rob Go said, on November 16, 2009 at 5:41 pm

    Nice Larry, I think this is your best post so far!

    • larrycheng said, on November 16, 2009 at 6:38 pm

      Glad to hear it Rob! Glad you liked it.

      • Lee Drucker said, on November 18, 2009 at 5:47 pm

        I am MBA student at NYU- and my economics professor played the exact same game yesterday- He made 39.99.

  4. Derek Pilling said, on November 16, 2009 at 6:48 pm

    Nice post Larry. The only issue is that the unabiguously “best strategy” for the game you outlined is to not play at all. You can’t get “pot-heavy” in this game and win; someone else will always outbid you.

    Not the case in VC of course; you can get pot-heavy, still build a great company and have a great outcome or a meaningful recovery of capital.

    The game does illustrate a point though; don’t play games you can’t win.

  5. Desmond Pieri said, on November 17, 2009 at 4:28 pm

    In the real world I’ve seen at least one case a few years back where the VCs put good money after bad, even when I — as interim CEO — told them, “It’d be best to cut your losses now.” Why? In this case the VC didn’t want to have to answer the question, “Why did you invest in the first place?” Because the problem that they saw now was a problem they should have seen before then ever invested. The VC chose to ignore the problem (or didn’t even see it) when they made the first investment, and now he can’t admit to either (ignoring or missing), so he plows more money in.

    I guess your game does simulate this problem. Had you “figure it out” in advance — and not quickly started the bidding with $5 — you’d have decided not to invest.

    I find it amazing that grown men sometimes can’t simply admit to their first mistake, so they plow forward, hoping for a good outcome when all the signs around them say, “It’d be best to cut your losses now.” Human nature, I guess.


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