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.